One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we'll use ROE to better understand NexPoint Residential Trust, Inc. (NYSE:NXRT).
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
See our latest analysis for NexPoint Residential Trust
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for NexPoint Residential Trust is:
4.9% = US$23m ÷ US$476m (Based on the trailing twelve months to December 2021).
The 'return' refers to a company's earnings over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.05.
Does NexPoint Residential Trust Have A Good Return On Equity?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, NexPoint Residential Trust has a lower ROE than the average (6.9%) in the REITs industry.
Unfortunately, that's sub-optimal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. To know the 7 risks we have identified for NexPoint Residential Trust visit our risks dashboard for free.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
NexPoint Residential Trust's Debt And Its 4.9% ROE
It appears that NexPoint Residential Trust makes extensive use of debt to improve its returns, because it has an alarmingly high debt to equity ratio of 3.27. We consider it to be a negative sign when a company has a rather low ROE despite a rather high debt to equity.