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 Transurban Group (ASX:TCL), by way of a worked example.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for Transurban Group

How Do You Calculate Return On Equity?

ROE 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 Transurban Group is:

2.1% = AU$267m ÷ AU$12b (Based on the trailing twelve months to December 2023).

The 'return' is the amount earned after tax over the last twelve months. So, this means that for every A$1 of its shareholder's investments, the company generates a profit of A$0.02.

Does Transurban Group 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, Transurban Group has a lower ROE than the average (4.8%) in the Infrastructure industry classification.

That certainly isn't ideal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. You can see the 2 risks we have identified for Transurban Group by visiting our risks dashboard for free on our platform here.

How Does Debt Impact ROE?

Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Transurban Group's Debt And Its 2.1% Return On Equity

It's worth noting the high use of debt by Transurban Group, leading to its debt to equity ratio of 1.49. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.