In This Article:
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 Tenaga Nasional Berhad (KLSE:TENAGA).
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. 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 Tenaga Nasional Berhad
How Is ROE Calculated?
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 Tenaga Nasional Berhad is:
6.2% = RM3.7b ÷ RM60b (Based on the trailing twelve months to September 2022).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each MYR1 of shareholders' capital it has, the company made MYR0.06 in profit.
Does Tenaga Nasional Berhad Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As shown in the graphic below, Tenaga Nasional Berhad has a lower ROE than the average (8.7%) in the Electric Utilities industry classification.
That certainly isn't ideal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. Our risks dashboard should have the 3 risks we have identified for Tenaga Nasional Berhad.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Tenaga Nasional Berhad's Debt And Its 6.2% ROE
Tenaga Nasional Berhad does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.05. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.