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 British American Tobacco (Malaysia) Berhad (KLSE:BAT), by way of a worked example.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

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ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for British American Tobacco (Malaysia) Berhad is:

47% = RM182m ÷ RM389m (Based on the trailing twelve months to September 2024).

The 'return' is the amount earned after tax over the last twelve months. That means that for every MYR1 worth of shareholders' equity, the company generated MYR0.47 in profit.

By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, British American Tobacco (Malaysia) Berhad has a higher ROE than the average (19%) in the Tobacco industry.

That's clearly a positive. However, bear in mind that a high ROE doesn't necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 3 risks we have identified for British American Tobacco (Malaysia) Berhad by visiting our risks dashboard for free on our platform here.

Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

British American Tobacco (Malaysia) Berhad clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.73. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. 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.