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). To keep the lesson grounded in practicality, we'll use ROE to better understand CyberOptics Corporation (NASDAQ:CYBE).
Our data shows CyberOptics has a return on equity of 5.6% for the last year. That means that for every $1 worth of shareholders' equity, it generated $0.056 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for CyberOptics:
5.6% = US$3.2m ÷ US$58m (Based on the trailing twelve months to June 2019.)
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. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Mean?
Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does CyberOptics Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in 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, CyberOptics has a lower ROE than the average (12%) in the Semiconductor industry.
That certainly isn't ideal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. 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 retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
CyberOptics's Debt And Its 5.6% ROE
CyberOptics is free of net debt, which is a positive for shareholders. Even though I don't think its ROE is that great, I think it's very respectable when you consider it has no debt. After all, with cash on the balance sheet, a company has a lot more optionality in good times and bad.
The Bottom Line On ROE
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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. So I think it may be worth checking this free report on analyst forecasts for the company.
But note: CyberOptics 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.
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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.