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.
To keep the lesson grounded in practicality, we’ll use ROE to better understand New Focus Auto Tech Holdings Limited (HKG:360).
Over the last twelve months New Focus Auto Tech Holdings has recorded a ROE of 5.5%.
One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.055 in profit.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for New Focus Auto Tech Holdings:
5.5% = CN¥108m ÷ CN¥985m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity.
It is all the money paid into the company from shareholders, plus any earnings retained.
Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Signify?
ROE measures a company’s profitability against the profit it retains, and any outside investments.
The ‘return’ is the yearly profit.
That means that the higher the ROE, the more profitable the company is.
So, all else being equal, a high ROE is better than a low one.
That means ROE can be used to compare two businesses.
Does New Focus Auto Tech Holdings Have A Good ROE?
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry.
The limitation of this approach is that some companies are quite different from others, even within the same industry classification.
As is clear from the image below, New Focus Auto Tech Holdings has a lower ROE than the average (13%) in the Auto Components industry.
That certainly isn’t ideal.
It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced.
Nonetheless, it could be useful to double-check if insiders have sold shares recently.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits.
That cash can come from issuing shares, 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 boost returns, but will not impact the shareholders’ equity.
In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining New Focus Auto Tech Holdings’s Debt And Its 5.5% Return On Equity
While New Focus Auto Tech Holdings does have some debt, with debt to equity of just 0.75, we wouldn’t say debt is excessive.
I’m not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects.
Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.
Return on equity is one way we can compare the business quality of different companies.
In my book the highest quality companies have high return on equity, despite low debt.
All else being equal, a higher ROE is better.
But when a business is high quality, the market often bids it up to a price that reflects this.
The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too.
Check the past profit growth by New Focus Auto Tech Holdings by looking at this visualization of past earnings, revenue and cash flow.
But note: New Focus Auto Tech Holdings may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
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