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Did BorgWarner Inc (NYSE:BWA) Use Debt To Deliver Its ROE Of 14%?

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 BorgWarner Inc (NYSE:BWA), by way of a worked example.

Over the last twelve months BorgWarner has recorded a ROE of 14%. One way to conceptualize this, is that for each $1 of shareholders’ equity it has, the company made $0.14 in profit.

Check out our latest analysis for BorgWarner

How Do I Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for BorgWarner:

14% = US$536m ÷ US$4.1b (Based on the trailing twelve months to June 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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.

Does BorgWarner Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that BorgWarner has an ROE that is roughly in line with the auto components industry average (14%).

NYSE:BWA Last Perf October 25th 18
NYSE:BWA Last Perf October 25th 18

That isn’t amazing, but it is respectable. Of course, this year’s ROE might be a product of last year’s decisions. So it makes sense to check how long the board and CEO have been in place.

How Does Debt Impact ROE?

Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.

Combining BorgWarner’s Debt And Its 14% Return On Equity

Although BorgWarner does use debt, its debt to equity ratio of 0.54 is still low. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.

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. In my book the highest quality companies have high return on equity, despite low debt. All else being equal, a higher ROE is better.

Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. 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.

But note: BorgWarner 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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

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