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. To keep the lesson grounded in practicality, we'll use ROE to better understand American Water Works Company, Inc. (NYSE:AWK).

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 other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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 American Water Works Company is:

9.4% = US$956m ÷ US$10b (Based on the trailing twelve months to June 2024).

The 'return' is the income the business earned over the last year. So, this means that for every $1 of its shareholder's investments, the company generates a profit of $0.09.

Does American Water Works Company 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. If you look at the image below, you can see American Water Works Company has a similar ROE to the average in the Water Utilities industry classification (9.4%).

That isn't amazing, but it is respectable. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. To know the 2 risks we have identified for American Water Works Company visit our risks dashboard for free.

Why You Should Consider Debt When Looking At 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.

American Water Works Company's Debt And Its 9.4% ROE

American Water Works Company does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.29. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

Summary

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.

But note: American Water Works Company may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low 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 account of 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.