While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We’ll use ROE to examine T-Mobile US, Inc. (NASDAQ:TMUS), 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. Put another way, it reveals the company’s success at turning shareholder investments into profits.
Check out our latest analysis for T-Mobile US
How Is ROE Calculated?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for T-Mobile US is:
2.2% = US$1.5b ÷ US$70b (Based on the trailing twelve months to September 2022).
The ‘return’ is the income the business earned over the last year. That means that for every $1 worth of shareholders’ equity, the company generated $0.02 in profit.
Does T-Mobile US Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As shown in the graphic below, T-Mobile US has a lower ROE than the average (6.4%) in the Wireless Telecom industry classification.
That’s not what we like to see. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, then there is still a chance that returns can be improved via the use of financial leverage. A high debt company having a low ROE is a different story altogether and a risky investment in our books. Our risks dashboard should have the 4 risks we have identified for T-Mobile US.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
T-Mobile US’ Debt And Its 2.2% ROE
T-Mobile US uses a high amount of debt to increase returns. It has a debt to equity ratio of 1.05. Its ROE is quite low, even with the use of significant debt; that’s not a good result, in our opinion. 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 one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. 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.
Of course T-Mobile US may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
What are the risks and opportunities for T-Mobile US?
T-Mobile US, Inc., together with its subsidiaries, provides mobile communications services in the United States, Puerto Rico, and the United States Virgin Islands.
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Rewards
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Trading at 42.5% below our estimate of its fair value
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Earnings are forecast to grow 33.94% per year
Risks
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Significant insider selling over the past 3 months
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Profit margins (1.9%) are lower than last year (4.2%)
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Large one-off items impacting financial results
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Has a high level of 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 into account 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.