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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. We’ll use ROE to examine China Nonferrous Mining Corporation Limited (

HKG:1258

), by way of a worked example.

Our data shows

China Nonferrous Mining has a return on equity of 24%

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$0.24.

See our latest analysis for China Nonferrous Mining

How Do You Calculate ROE?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for China Nonferrous Mining:

24% = 175.645 ÷ US$1.2b (Based on the trailing twelve months to June 2018.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 ROE Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal,

investors should like a high ROE

. That means it can be interesting to compare the ROE of different companies.

Does China Nonferrous Mining Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, China Nonferrous Mining has a superior ROE than the average (12%) company in the Metals and Mining industry.

SEHK:1258 Last Perf February 1st 19

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.

How Does Debt Impact Return On Equity?

Virtually all companies need money to invest in the business, to grow 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 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.

Story continues

Combining China Nonferrous Mining’s Debt And Its 24% Return On Equity

China Nonferrous Mining does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.05. There’s no doubt its ROE is impressive, but the company appears to use its debt to boost that metric. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

The Bottom Line On ROE

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. Check the past profit growth by China Nonferrous Mining by looking at this

visualization of past earnings, revenue and cash flow

.

If you would prefer check out another company — one with potentially superior financials — then do not miss this

free

list of interesting companies, that have HIGH return on equity and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at

[email protected]

.

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