While some investors are already familiar with financial ratios (hats off to them), this article is for those who want to learn more about return on equity (ROE) and what it means. We’ll use ROE with a worked example to examine Iridium Communications Inc. (NASDAQ:IRDM).
Return on equity (ROE) is an important metric used to assess how efficiently a company’s management is using its capital. In simpler terms, it measures a company’s profitability relative to its equity.
Check out our latest analysis for Iridium Communications
How do you calculate return on equity?
Return on equity can be calculated using the following formula:
Return on equity = Net profit (from continuing operations) ÷ Equity
Based on the above formula, the ROE for Iridium Communications is:
11% = $88 million ÷ $787 million (based on the trailing twelve months ending June 2024).
The “return” is the income that the company generated in the last year. You can also imagine it like this: for every dollar of equity, the company was able to generate $0.11 in profit.
Does Iridium Communications have a good return on equity?
By comparing a company’s return on equity to the industry average, we can quickly gauge how well it is doing. Importantly, this is far from a perfect measure, as companies within the same industry classification vary considerably. In the chart below, you can see that Iridium Communications has a return on equity that is fairly close to the Telecommunications industry average (12%).
While the return on equity is not exceptional, it is acceptable. Even though the return on equity is respectable compared to the industry, it is worth checking whether the company’s return on equity is being helped by high levels of debt. If so, this increases financial risk. To learn about the 3 risks we have identified for Iridium Communications, visit our risk dashboard for free.
The importance of debt for return on equity
Most companies need money – from somewhere – to grow their profits. The money for investments can come from previous year’s profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the return on equity will reflect this use of cash for growth. In the latter case, the use of debt will improve the return but will not change the equity. In this way, the use of debt will increase the return on equity even if the company’s core economics remain the same.
Iridium Communications’ debt and its 11% return on equity
Iridium Communications is clearly using a high level of debt to boost returns, as the debt to equity ratio is 2.10. The combination of a rather low return on equity and a significant level of debt is not particularly attractive. Debt brings additional risks and is therefore only really worthwhile if a company can generate decent returns with it.
Summary
Return on equity is useful for comparing the quality of different companies. A company that can generate a high return on equity without using debt could be considered a high-quality company. If two companies have roughly the same debt-to-equity ratio and one has a higher return on equity, I would generally prefer the company with the higher return on equity.
However, if a company is of high quality, the market will often bid it up at a price that reflects this. It’s important to consider other factors such as future earnings growth – and how much investment is required going forward. 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.
