While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. We will use ROE to examine Aker BP ASA (OB: AKRBP), through a worked example.

Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In short, the ROE shows the profit that each dollar generates compared to the investments of its shareholders.

Check out our latest analysis for Aker BP

How is the ROE calculated?

Return on equity can be calculated using the formula:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the above formula, the ROE for Aker BP is:

29% = US $ 616 million ÷ US $ 2.1 billion (based on the last twelve months to September 2021).

The “return” is the annual profit. One way to conceptualize this is that for every NOK1 of shareholders’ capital it has, the company made a profit of NOK0.29.

Does Aker BP have a good return on equity?

An easy way to determine if a company has a good return on equity is to compare it to the average in its industry. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As shown in the image below, Aker BP has a better ROE than the oil and gas industry average (14%).

This is what we love to see. Keep in mind that a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk. Our risk dashboard should include the 5 risks that we have identified for Aker BP.

Why You Should Consider Debt When Looking At ROE

Businesses generally need to invest money to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt necessary for growth will increase returns, but will have no impact on equity. This will make the ROE better than if no debt was used.

Aker BP’s debt and its ROE of 29%

Note the heavy use of debt by Aker BP, which earned it a debt / equity ratio of 1.69. While there is no doubt that its ROE is impressive, we would have been even more impressed if the company had achieved this goal with lower debt. Debt comes with additional risk, so it’s only really worth it when a business is making decent returns from it.

Conclusion

Return on equity is a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. 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. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So you might want to check out this FREE visualization of analyst forecasts for the business.

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.

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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.