While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. To keep the lesson grounded in practicality, we’ll use ROE to better understand Black Hills Corporation (NYSE: BKH).
Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check out our latest analysis for Black Hills
How to calculate return on equity?
The ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for Black Hills is:
9.4% = $279 million ÷ $3.0 billion (based on trailing 12 months to June 2022).
“Yield” refers to a company’s earnings over the past year. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.09.
Does Black Hills have a good ROE?
By comparing a company’s ROE with the average for its industry, we can get a quick measure of its quality. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. You can see in the chart below that Black Hills has an ROE quite close to the integrated utilities industry average (8.9%).
It’s not surprising, but it’s respectable. Even if the ROE is respectable compared to the industry, it is worth checking whether the company’s ROE is helped by high debt levels. If so, this increases its exposure to financial risk. You can see the 3 risks we have identified for Black Hills by visiting our risk dashboard for free on our platform here.
Why You Should Consider Debt When Looking at ROE
Most businesses need money – from somewhere – to increase their profits. This money can come from retained earnings, issuing new stock (shares), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, debt used for growth will enhance returns, but will not affect total equity. This will make the ROE better than if no debt was used.
Combining Black Hills debt and its 9.4% return on equity
Black Hills clearly uses a high amount of debt to boost returns, as it has a leverage ratio of 1.50. With a fairly low ROE and a significant reliance on debt, it is difficult to get enthusiastic about this activity at the moment. Debt brings additional risk, so it’s only really worth it when a business is generating decent returns.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, I would generally prefer the one with less debt.
But when a company is of high quality, the market often gives it a price that reflects that. Earnings growth rates, relative to expectations reflected in the share price, are particularly important to consider. So I think it’s worth checking it out free analyst forecast report for the company.
Sure Black Hills may not be the best stock to buy. So you might want to see this free collection of other companies that have high ROE and low debt.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
Valuation is complex, but we help make it simple.
Find out if black hills is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
See the free analysis