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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 China Molybdenum Co Ltd (HKG:3993), by way of a worked example.
China Molybdenum has a ROE of 12%, 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$0.12.
View our latest analysis for China Molybdenum
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for China Molybdenum:
12% = CN¥5.0b ÷ CN¥47.9b (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. 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 ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does China Molybdenum 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 China Molybdenum has an ROE that is fairly close to the average for the metals and mining industry (12%).
That’s not overly surprising. Generally it will take a while for decisions made by leadership to impact the ROE. So I like to check the tenure of the board and CEO, before reaching any conclusions.
The Importance Of Debt To Return On Equity
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 first two cases, the ROE will capture this use of capital to grow. 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 China Molybdenum’s Debt And Its 12% Return On Equity
China Molybdenum has a debt to equity ratio of 0.64, which is far from excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.