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. We'll use ROE to examine Shanghai Fudan Microelectronics Group Company Limited (HKG:1385), by way of a worked example.
Our data shows Shanghai Fudan Microelectronics Group has a return on equity of 6.1% for the last year. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.061.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Shanghai Fudan Microelectronics Group:
6.1% = CN¥107m ÷ CN¥2.1b (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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Mean?
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, 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 Shanghai Fudan Microelectronics Group 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. You can see in the graphic below that Shanghai Fudan Microelectronics Group has an ROE that is fairly close to the average for the Semiconductor industry (6.8%).
That's not overly surprising. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. I will like Shanghai Fudan Microelectronics Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Combining Shanghai Fudan Microelectronics Group's Debt And Its 6.1% Return On Equity
Shanghai Fudan Microelectronics Group 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, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow .
But note: Shanghai Fudan Microelectronics Group 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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