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. We'll use ROE to examine Cogeco Communications Inc. (TSE:CCA), by way of a worked example.

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 simpler terms, it measures the profitability of a company in relation to shareholder's equity.

View our latest analysis for Cogeco Communications

How Is ROE Calculated?

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 Cogeco Communications is:

10% = CA$360m ÷ CA$3.5b (Based on the trailing twelve months to May 2024).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each CA$1 of shareholders' capital it has, the company made CA$0.10 in profit.

Does Cogeco Communications 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. You can see in the graphic below that Cogeco Communications has an ROE that is fairly close to the average for the Telecom industry (10%).

That's neither particularly good, nor bad. 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 true, then it is more an indication of risk than the potential.

Why You Should Consider Debt When Looking At ROE

Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Cogeco Communications' Debt And Its 10% ROE

It's worth noting the high use of debt by Cogeco Communications, leading to its debt to equity ratio of 1.41. 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.