Many investors are still learning the different metrics that can be useful when analyzing a stock. This article is for those who want to know more about return on equity (ROE). To keep the lesson grounded in practicality, we’ll use ROE to better understand American Assets Trust, Inc. (NYSE: AAT).
Return on Equity or ROE is a test of how effectively a company increases its value and manages investors’ money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the company’s shareholders.
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How is ROE calculated?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for American Assets Trust is:
4.2% = $50 million ÷ $1.2 billion (based on trailing 12 months to June 2022).
“Yield” refers to a company’s earnings over the past year. Another way to think about this is that for every dollar of equity, the company was able to make a profit of $0.04.
Does American Assets Trust have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industrial classification. As the image below clearly shows, American Assets Trust has an ROE below the REIT industry average (6.6%).
Unfortunately, this is suboptimal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is always a chance that returns can be enhanced through the use of leverage. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. Our risk dashboard should have the 2 risks we identified for American Assets Trust.
Why You Should Consider Debt When Looking at ROE
Companies generally need to invest money to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, debt used for growth will enhance returns, but will not affect total equity. This will make the ROE better than if no debt was used.
Combination of American Assets Trust’s debt and its return on equity of 4.2%
American Assets Trust uses a high amount of debt to increase returns. Its debt to equity ratio is 1.37. With a fairly low ROE and a significant reliance on debt, it is difficult to get enthusiastic about this activity at the moment. Investors need to think carefully about how a company would perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt and one has a higher ROE, I generally prefer the one with a higher ROE.
That said, while ROE is a useful indicator of a company’s quality, you’ll need to consider a whole host of factors to determine the right price to buy a stock. It is important to consider other factors, such as future earnings growth and the amount of investment needed in the future. So I think it’s worth checking it out free analyst forecast report for the company.
But note: American Assets Trust may 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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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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