One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return On Equity (ROE) to better understand a company. We’ll use ROE to examine Eli Lilly and Company (NYSE:LLY) as a worked example.

ROE or return on equity is a useful tool for assessing how effectively a company can generate returns on the investment it has received from its shareholders. In other words, it shows how successful the company is in converting shareholder investments into profits.

Check out our latest analysis for Eli Lilly

How is ROE calculated?

The formula for ROE is:

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

So, based on the formula above, the ROE for Eli Lilly is:

54% = $7.3 billion ÷ $14 billion (based on trailing twelve months to June 2024).

The ‘return’ is the profit over the past twelve months. So this means that for every $1 of its shareholders’ investments, the company generates a profit of $0.54.

Does Eli Lilly have a good return on equity?

The easiest way to assess a company’s ROE is to compare it with the industry average. However, this method is only useful as a rough check, because companies within the same industry classification are quite different from each other. Fortunately, Eli Lilly has a higher ROE than the average (22%) in the pharmaceutical industry.

That’s a good sign. That said, a high ROE does not always indicate high profitability. Especially when a company uses high debt to finance its debt, which can increase ROE, but the high debt burden puts the company at risk. Our risk dashboard should include the two risks we identified for Eli Lilly.

How does debt affect ROE?

Almost all businesses need money to invest in the business and grow profits. That money can come from issuing stock, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt required for growth will increase returns but have no impact on equity. Thus, the use of debt can improve return on equity, albeit metaphorically speaking with additional risk in the event of stormy weather.

Eli Lilly’s debt and its 54% ROE

Eli Lilly is clearly using a large amount of debt to boost returns, as the company has a debt-to-equity ratio of 2.13. The ROE is quite impressive, but would probably have been lower without the use of debt. Investors need to think carefully about how a company might perform if it couldn’t borrow as easily, because credit markets change over time.

The story continues

Summary

Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can achieve a high return on equity without too much debt are generally of good quality. If two companies have about the same level of debt as equity, and one company has a higher return on equity, I would generally prefer the company with a higher return on equity.

But ROE is just one piece of a bigger puzzle, as high-quality companies often trade on high profit margins. The rate at which profits are likely to grow should also be taken into account, relative to the expectations of earnings growth reflected in the current price. So you might want to take a look at this data-rich, interactive graph of company forecasts.

But beware: Eli Lilly may not be the best stock to buy. So take a look at this free list of interesting companies with a high return on equity and a low debt burden.

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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. We aim to provide you with targeted, long-term analysis based on fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no positions in the stocks mentioned.