One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We'll use ROE to examine Kinder Morgan, Inc. (NYSE:KMI), 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Kinder Morgan

How Is ROE Calculated?

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 Kinder Morgan is:

8.5% = US$2.7b ÷ US$32b (Based on the trailing twelve months to December 2024).

The 'return' is the yearly profit. That means that for every $1 worth of shareholders' equity, the company generated $0.09 in profit.

Does Kinder Morgan Have A Good Return On Equity?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Kinder Morgan has a lower ROE than the average (14%) in the Oil and Gas industry classification.

Unfortunately, that's sub-optimal. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. Our risks dashboard should have the 3 risks we have identified for Kinder Morgan.

How Does Debt Impact ROE?

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 two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

Combining Kinder Morgan's Debt And Its 8.5% Return On Equity

Kinder Morgan clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.01. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

Conclusion

Return on equity is useful for comparing the quality of different businesses. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.