One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. We will use the ROE to examine Science Applications International Corporation (NYSE: SAIC), using a real-world example.
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
How is the ROE calculated?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of Science Applications International is:
18% = US $ 285 million ÷ US $ 1.6 billion (based on the last twelve months to July 2021).
The “return” is the annual profit. One way to conceptualize this is that for every $ 1 of shareholder capital it has, the company has made $ 0.18 in profit.
Does Science Applications International have a good ROE?
An easy way to determine if a company has a good return on equity is to compare it to the average in its industry. The limitation of this approach is that some companies are very different from others, even within the same industry classification. You can see from the graph below that Science Applications International has a ROE quite close to the professional services industry average (16%).
NYSE: SAIC Return on Equity November 2, 2021
So even if the ROE is not exceptional, it is at least acceptable. While at least the ROE is not lower than that of the industry, it is still worth checking out the role that corporate debt plays, as high levels of debt relative to equity can also make the ROE appear high. If so, it increases their exposure to financial risk. To know the 2 risks that we have identified for Science Applications International visit our risk dashboard for free.
What is the impact of debt on ROE?
Almost all businesses need money to invest in the business, to increase their profits. This liquidity can come from the issuance of shares, retained earnings 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 debt necessary for growth will increase returns, but will have no impact on equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
The debt of Science Applications International and its ROE of 18%
Science Applications International uses a large amount of debt to increase returns. Its debt ratio is 1.64. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. Debt comes with additional risk, so it’s only really worth it when a business is making decent returns from it.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. All other things being equal, a higher ROE is preferable.
But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So you may want to check this out for FREE viewing analyst forecasts for the company.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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