Did AstraZeneca PLC (LON:AZN) Use Debt To Deliver Its ROE Of 15%?
Many investors are still learning about the various metrics that can be helpful in analyzing a stock. This article is for those who want to learn more about Return On Equity (ROE). In learning-by-doing, we will look at the ROE to get a better understanding of the AstraZeneca PLC (LON: AZN).
Return on Equity, or ROE, is a test of how effectively a company is increasing its value and managing investors' money. In simpler terms, it measures a company's profitability in relation to equity.
Check out our latest analysis for AstraZeneca
How is the ROE calculated?
The return on equity can be calculated using the following formula:
Return on Equity = Net Income (from continuing operations) ÷ Equity
So based on the formula above, the ROE for AstraZeneca is:
15% = $ 2.0 billion ÷ $ 14 billion (based on the last twelve months through June 2020).
"Return" refers to a company's earnings over the past year. One way to conceptualize this is for the company to make a profit of £ 0.15 for every £ 1 of equity.
Does AstraZeneca have a good return on equity?
By comparing a company's ROE to its industry average, we can quickly determine how good it is. The limitation of this approach is that some companies are very different from others, even within the same industry classification. If you look at the picture below, you can see that AstraZeneca has a ROE similar to the average in the pharmaceutical industry classification (16%).
This is neither particularly good nor bad. Even if the ROE is respectable compared to the industry, it is worth checking whether the company's ROE is supported by high levels of debt. In this case, the financial risk increases. Our risk dashboards should include the 3 risks that we have identified for AstraZeneca.
How does debt affect ROE?
Virtually all businesses need money to invest in the business and make a profit. The money for investments can come from profits of the previous year (retained earnings), the issue of new shares or the taking out of loans. For the first and second options, the ROE will reflect this use of cash for growth. In the latter case, the debt used for growth will improve returns, but will not affect total equity. Thus, using debt can improve ROE, albeit metaphorically an additional risk in stormy weather.
AstraZeneca's debt and its 15% ROE
AstraZeneca clearly uses high leverage to increase returns as it has a leverage ratio of 1.57. There's no doubt the ROE is reasonable, but the company's very high level of debt isn't all that exciting to see. Debt increases risk and reduces options for the company in the future. Hence, in general, you want to get good returns from using it.
Return on equity is useful for comparing the quality of different companies. Companies that can achieve high returns on equity without excessive debt are usually of good quality. When everything else is the same, a higher ROE is better.
The ROE is only part of a bigger puzzle, however, as high-quality companies often trade with a large multiple of their income. The rate at which earnings are expected to grow relative to the expectations of earnings growth reflected in the current price must also be taken into account. You may want to check out this FREE analyst forecast visualization for the company.
Of course, you could find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
This article from Simply Wall St is of a general nature. It is not a recommendation to buy or sell stocks and does not take into account your goals or your financial situation. We want to provide you with a long-term, focused analysis based on fundamental data. Note that our analysis may not take into account the latest price sensitive company announcements or quality materials. Simply Wall St has no position in the stocks mentioned.
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