One of the best investments we can make is in our own knowledge and skills. With this in mind, this article will explain 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) with a practical example.

ROE or return on equity is a useful tool for assessing how effectively a company can generate returns on the investments it receives from its shareholders. In other words, it shows the company's success 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) ÷ equity

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

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

The “return” is the profit over the last twelve months. So this means that for every dollar that its shareholders invest, the company generates a profit of $0.54.

Does Eli Lilly have a good return on equity?

Perhaps the easiest way to assess a company's ROE is to compare it to the average for its industry. However, this method is only useful for a rough check, as companies within the same industry classification differ greatly. Pleasingly, Eli Lilly has a higher ROE than the average (22%) in the pharmaceutical industry.

That's a good sign. However, a high ROE does not always mean high profitability. Especially when a company uses a high level of debt to finance its debt, which can increase its ROE, but the high level of debt exposes the company to risk. Our risk dashboard should include the two risks we have identified for Eli Lilly.

How does debt affect ROE?

Virtually all companies need money to invest in the business and increase profits. This money can come from issuing shares, retained earnings, or debt. In the first two cases, ROE will capture this use of capital for growth. In the latter case, the debt required for growth will increase returns but will not affect equity. Thus, the use of debt can improve ROE, although metaphorically speaking it comes with additional risk in stormy weather.

Eli Lilly's debt and its ROE of 54%

Eli Lilly is clearly using high debt to boost returns, as its debt-to-equity ratio is 2.13. The ROE is pretty impressive, but without the use of debt it would probably have been lower. Investors should think carefully about how a company would perform if it could not easily borrow, as 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 distribute them to shareholders. Companies that can generate a high return on equity without too much debt are usually of good quality. If two companies have roughly the same debt-to-equity ratio and one has a higher ROE, I would generally prefer the company with a higher ROE.

However, ROE is just one piece of a larger puzzle, as high-quality companies often trade at a high earnings multiple. It is also important to consider the rate at which earnings are likely to grow relative to the earnings growth expectations reflected in the current price. You might want to take a look at this data-rich interactive chart showing forecasts for the company.

But note: Eli Lilly may not be the best stock to buy. So take a look free List of interesting companies with high ROE and low debt.

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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 does not constitute a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term focused analysis based on fundamental data. Note that our analysis may not reflect the latest price-sensitive company announcements or qualitative material. Simply Wall St has no positions in any stocks mentioned.