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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine New Focus Auto Tech Holdings Limited (HKG:360), by way of a worked example.
New Focus Auto Tech Holdings has a ROE of 5.5%, based on the last twelve months. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.055.
See our latest analysis for New Focus Auto Tech Holdings
How Do You Calculate Return On Equity?
The formula for ROE 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.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does New Focus Auto Tech Holdings Have A Good ROE?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As shown in the graphic below, New Focus Auto Tech Holdings has a lower ROE than the average (14%) in the Auto Components industry classification.
Unfortunately, that's sub-optimal. 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?
Most companies need money -- from somewhere -- 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.