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). By way of learning-by-doing, we'll look at ROE to gain a better understanding of Fusen Pharmaceutical Company Limited (HKG:1652).
Fusen Pharmaceutical has a ROE of 17%, based on the last twelve months. One way to conceptualize this, is that for each HK$1 of shareholders' equity it has, the company made HK$0.17 in profit.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Fusen Pharmaceutical:
17% = CN¥102m ÷ CN¥616m (Based on the trailing twelve months to December 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. 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 Return On Equity Signify?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does Fusen Pharmaceutical 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 is clear from the image below, Fusen Pharmaceutical has a better ROE than the average (13%) in the Pharmaceuticals industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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 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.
Fusen Pharmaceutical's Debt And Its 17% ROE
Fusen Pharmaceutical has a debt to equity ratio of 0.31, which is far from excessive. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. 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.
The Bottom Line On ROE
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 ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow .
But note: Fusen Pharmaceutical 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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