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’s important. As a learning by doing, we’ll take a look at the ROE to better understand FLEX LNG Ltd. (OB: FLNG).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. Simply put, it is used to assess a company’s profitability against its equity.
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How to calculate return on equity?
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 of FLEX LNG is:
8.2% = US $ 70 million ÷ US $ 861 million (based on the last twelve months to March 2021).
The “return” is the annual profit. Another way to look at this is that for every NOK1 value of equity, the company was able to make NOK0.08 in profit.
Does FLEX LNG have a good ROE?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a little within the same industry classification. As shown in the graph below, FLEX LNG has a lower ROE than the oil and gas industry classification average (17%).
Unfortunately, this is suboptimal. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing leverage levels are low. A business with high debt levels and low ROE is a combination we like to avoid given the risk involved. You can see the 4 risks we have identified for FLEX LNG by visiting our risk dashboard for free on our platform here.
The importance of debt to return on equity
Businesses generally need to invest money to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but will not affect total equity. This will make the ROE better than if no debt was used.
FLEX LNG’s debt and its ROE of 8.2%
FLEX LNG clearly uses a high amount of debt to increase returns, as it has a debt-to-equity ratio of 1.11. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.
summary
Return on equity is useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. 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. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So I think it’s worth checking this out free analyst forecast report for the company.
But beware : FLEX LNG might not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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