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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Reckitt Benckiser Group plc (LON:RKT), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.
How Is ROE Calculated?
ROE 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 Reckitt Benckiser Group is:
21% = UK£1.4b ÷ UK£6.7b (Based on the trailing twelve months to December 2024).
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 £0.21.
View our latest analysis for Reckitt Benckiser Group
Does Reckitt Benckiser Group Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Reckitt Benckiser Group has a higher ROE than the average (13%) in the Household Products industry.
That is a good sign. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. Our risks dashboardshould have the 3 risks we have identified for Reckitt Benckiser Group.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Reckitt Benckiser Group's Debt And Its 21% ROE
Reckitt Benckiser Group does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.27. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.