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Should We Be Cautious About Vector Limited's (NZSE:VCT) ROE Of 3.6%?

Simply Wall St
·4-min read

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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Vector Limited (NZSE:VCT).

Over the last twelve months Vector has recorded a ROE of 3.6%. One way to conceptualize this, is that for each NZ$1 of shareholders' equity it has, the company made NZ$0.04 in profit.

Check out our latest analysis for Vector

How Do I Calculate ROE?

The formula for ROE is:

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

Or for Vector:

3.6% = NZ$84m ÷ NZ$2.3b (Based on the trailing twelve months to June 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Signify?

Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.

Does Vector Have A Good ROE?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Vector has a lower ROE than the average (9.8%) in the Integrated Utilities industry.

NZSE:VCT Past Revenue and Net Income, February 17th 2020
NZSE:VCT Past Revenue and Net Income, February 17th 2020

That certainly isn't ideal. It is better when the ROE is above industry average, but a low one doesn't necessarily mean the business is overpriced. Still, shareholders might want to check if insiders have been selling.

The Importance Of Debt To Return On Equity

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 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.

Vector's Debt And Its 3.6% ROE

Vector clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.18. Its ROE isn't too bad, but it would probably be very disappointing if the company had to stop using debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

But It's Just One Metric

Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

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

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.