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. As a learning-by-doing, we’ll take a look at the ROE to better understand Air Transport Services Group, Inc. (NASDAQ: ATSG).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
See our latest analysis for Air Transport Services Group
How to calculate return on equity?
the formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE for Air Transport Services Group is:
16% = US $ 187 million ÷ US $ 1.2 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 $ 1 of shareholder capital it has, the company has made $ 0.16 in profit.
Does the Airline Services Group 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 Air Transport Services Group has a ROE quite close to the average for the Logistics sector (17%).
It’s no wonder, but it’s respectable. Although the ROE is similar to that of the industry, we still need to perform additional checks to see if the company’s ROE is being boosted by high levels of debt. If so, it increases their exposure to financial risk. Our risk dashboard must include the 4 risks that we have identified for the Air Transport Services group.
The importance of debt to return on equity
Almost all businesses need money to invest in the business, 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 and second cases, the ROE will reflect this use of cash for investing in the business. 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.
The debt of the Air Transport Services group and its ROE of 16%
The Airline Services group clearly uses a high amount of debt to boost returns, as it has a debt-to-equity ratio of 1.16. 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. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using it.
Return on equity is a way to compare the business quality of different companies. A business that can earn a high return on equity without going into debt can be considered a high quality business. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. 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 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.