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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 XP Power Limited (LON:XPP), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for XP Power
How To Calculate Return On Equity?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for XP Power is:
18% = UK£24m ÷ UK£132m (Based on the trailing twelve months to June 2023).
The 'return' is the income the business earned over the last year. That means that for every £1 worth of shareholders' equity, the company generated £0.18 in profit.
Does XP Power 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, XP Power has a superior ROE than the average (13%) in the Electrical industry.
That's clearly a positive. With that said, a high ROE doesn't always indicate high profitability. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . You can see the 3 risks we have identified for XP Power by visiting our risks dashboard for free on our platform here.
How Does Debt Impact ROE?
Companies usually need to invest money 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 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.
Combining XP Power's Debt And Its 18% Return On Equity
XP Power clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.33. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.