One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a company. To keep the lesson practical, we will use ROE to better understand Kodiak Gas Services, Inc. (NYSE:KGS).

Return on equity, or ROE, is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates relative to their shareholder investment.

Check out our latest analysis for Kodiak Gas Services

How do you calculate return on equity?

ROE can be calculated using the following formula:

Return on equity = Net profit (from continuing operations) ÷ Equity

Based on the above formula, the ROE for Kodiak Gas Services is:

5.5% = $63 million ÷ $1.1 billion (based on the trailing twelve months ending March 2024).

“Return” refers to a company’s earnings over the last year. This means that for every dollar of equity, the company earned $0.05 in profit.

Does Kodiak Gas Services have a good return on equity?

Arguably the easiest way to determine a company’s return on equity is to compare it to the industry average. The limitation of this approach is that some companies differ greatly from others, even within the same industry. As shown in the chart below, Kodiak Gas Services has a lower return on equity than the average (13%) in the Energy Services industry classification.

We don’t like to see that. However, a low return on equity is not always a bad thing, especially if the company has little debt, as there is still room for improvement here if the company takes on more debt. If a company has a low return on equity but high debt, we would be cautious as the risk involved is too high. To learn about the 3 risks we have identified for Kodiak Gas Services, visit our risk dashboard for free.

Why you should consider debt when looking at ROE

Almost all companies need money to invest in their business and grow their profits. This money can come from issuing stock, retained earnings, or debt. In the first and second options, the return on equity reflects this use of cash for growth. In the second case, the debt required for growth increases the return but has no impact on the equity. This makes the return on equity look better than if no debt had been taken on.

Kodiak Gas Services’ debt and return on equity of 5.5%

Kodiak Gas Services actually takes on a high amount of debt to boost returns. Its debt to equity ratio is 1.60. With a relatively low return on equity and significant leverage, it’s hard to get excited about this business right now. Debt brings additional risk, so it’s only really worth it if a company is generating a decent return on it.

Summary

Return on equity is a way to compare the quality of different companies. A company that can generate a high return on equity without any debt can be considered a high-quality company. All else being equal, a higher return on equity is better.

But return on equity is just one piece of a larger puzzle, as high-quality companies often trade at high earnings multiples. The rate at which earnings are expected to grow, relative to earnings growth expectations reflected in the current price, must also be considered, so you may want to take a look at this data-rich interactive chart showing forecasts for the company.

Naturally Kodiak Gas Services may not be the best stock to buy. You may want to see this free Collection of other companies with high return on equity and low debt.

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This Simply Wall St article is of a general nature. We comment solely on the basis of historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.