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. As part of the learning-by-doing principle, we will look at ROE to gain a better understanding of United Rentals, Inc. (NYSE:URI).
Return on equity (ROE) is a measure of how effectively a company increases its value and manages its investors’ money. In other words, it is a profitability ratio that measures the return on the capital provided by the company’s shareholders.
Check out our latest analysis for United Rentals
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 return on equity for United Rentals is:
31% = $2.6 billion ÷ $8.3 billion (based on the trailing twelve months ending June 2024).
The “return” is the annual profit. You can imagine it like this: for every dollar of shareholder capital, the company made $0.31 in profit.
Does United Rentals 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. Importantly, this is far from a perfect measure, as companies vary considerably within the same industry classification. As can be seen in the figure below, United Rentals has a better return on equity than the average (16%) in the Commercial Distribution industry.
We like to see that. However, keep in mind that a high return on equity is not necessarily a sign of efficient profit generation. A higher level of debt in a company’s capital structure can also lead to a high return on equity, although a high level of debt can represent a high risk.
What impact does debt have on return on equity?
Companies usually need to invest money to grow their profits. This money can come from retained earnings, issuing new shares (equity), or from debt. In the first two cases, the return on equity will capture this use of capital for growth. In the latter case, the debt used for growth will improve the return but will not affect total equity. This will make the return on equity look better than if no debt had been used.
United Rentals’ debt and return on equity of 31%
United Rentals actually takes on a high amount of debt to increase returns. Its debt to equity ratio is 1.53. The return on equity is quite impressive, but would likely have been lower without debt. Debt increases risk and reduces the company’s options in the future, so you generally want to get a good return from taking on debt.
Summary
Return on equity is a way to compare the business quality of different companies. A company that can generate a high return on equity without any debt could be considered a high-quality company. If two companies have the same return on equity, I would generally prefer the company with the lower debt.
However, if a company is of high quality, the market will often bid it up at a price that reflects this. It is particularly important to consider earnings growth rates compared to expectations reflected in the share price, so you may want to take a look at this data-rich interactive chart showing forecasts for the company.
If you would rather try another company — one with potentially better financials — then don’t miss this free List of interesting 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.
