While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine SJW Group (NYSE:SJW), by way of a worked example.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

Check out our latest analysis for SJW Group

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for SJW Group is:

8.2% = US$100m ÷ US$1.2b (Based on the trailing twelve months to September 2023).

The 'return' refers to a company's earnings over the last year. That means that for every $1 worth of shareholders' equity, the company generated $0.08 in profit.

Does SJW Group Have A Good Return On Equity?

One simple way to determine if a company has a good return on equity is to compare it to the average for 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 SJW Group has an ROE that is fairly close to the average for the Water Utilities industry (8.2%).

That isn't amazing, but it is respectable. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. You can see the 3 risks we have identified for SJW Group by visiting our risks dashboard for free on our platform here.

The Importance Of Debt To Return On Equity

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining SJW Group's Debt And Its 8.2% Return On Equity

It's worth noting the high use of debt by SJW Group, leading to its debt to equity ratio of 1.40. The combination of a rather low ROE and significant use of debt is not particularly appealing. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.