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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. To keep the lesson grounded in practicality, we'll use ROE to better understand NXP Semiconductors N.V. (NASDAQ:NXPI).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for NXP Semiconductors is:
27% = US$2.5b ÷ US$9.5b (Based on the trailing twelve months to December 2024).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.27 in profit.
See our latest analysis for NXP Semiconductors
Does NXP Semiconductors Have A Good Return On Equity?
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. Pleasingly, NXP Semiconductors has a superior ROE than the average (12%) in the Semiconductor industry.
That's clearly a positive. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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 used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
NXP Semiconductors' Debt And Its 27% ROE
NXP Semiconductors does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.14. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.