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.  We'll use ROE to examine CenterPoint Energy, Inc. (NYSE:CNP), by way of a worked example.  

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for CenterPoint Energy is:

9.5% = US$917m ÷ US$9.7b (Based on the trailing twelve months to December 2023).

The 'return' refers to a company's earnings over the last year.  One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.09 in profit.

Does CenterPoint Energy Have A Good Return On Equity?

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.   You can see in the graphic below that CenterPoint Energy has an ROE that is fairly close to the average for the Integrated Utilities industry (9.5%).  

NYSE:CNP Return on Equity March 10th 2024

That isn't amazing, but it is respectable.    Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels.  If a company takes on too much debt, it is at higher risk of defaulting on interest payments.    Our risks dashboardshould have the 2 risks we have identified for CenterPoint Energy.  

The Importance Of Debt To Return On Equity

Companies usually need to invest money to grow their profits.  That cash can come from issuing shares, retained earnings, or debt.  In the first and second cases, the ROE will reflect this use of cash for investment in the business.  In the latter case, the debt used for growth will improve returns, but won't affect the total equity.  That will make the ROE look better than if no debt was used.

Combining CenterPoint Energy's Debt And Its 9.5% Return On Equity

It's worth noting the high use of debt by CenterPoint Energy, leading to its debt to equity ratio of 1.93.   The combination of a rather low ROE and significant use of debt is not particularly appealing.   Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.  

Conclusion  

Return on equity is useful for comparing the quality of different businesses.  A company that can achieve a high return on equity without debt could be considered a high quality business.  If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But when a business is high quality, the market often bids it up to a price that reflects this.  It is important to consider other factors, such as future profit growth -- and how much investment is required going forward.   So I think it may be worth checking this free report on analyst forecasts for the company.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.