Yahoo Finance Is Mount Gibson Iron Limited’s (ASX:MGX) 20% ROE Strong Compared To Its Industry?
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 Mount Gibson Iron Limited (ASX:MGX), by way of a worked example.
Mount Gibson Iron has a ROE of 20%, based on the last twelve months. One way to conceptualize this, is that for each A$1 of shareholders’ equity it has, the company made A$0.20 in profit.
Check out our latest analysis for Mount Gibson Iron
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Mount Gibson Iron:
20% = AU$99m ÷ AU$497m (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 the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.
What Does ROE Signify?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the amount earned after tax over the last twelve months. 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 Mount Gibson Iron Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Mount Gibson Iron has a superior ROE than the average (14%) company in the metals and mining industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
The Importance Of Debt To Return On Equity
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 and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Mount Gibson Iron’s Debt And Its 20% ROE
One positive for shareholders is that Mount Gibson Iron does not have any net debt! Its ROE already suggests it is a good business, but the fact it has achieved this — and doesn’t borrowings — makes it worthy of further consideration, in my view. After all, with cash on the balance sheet, a company has a lot more optionality in good times and bad.
In Summary
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. If two companies have the same ROE, then I would generally prefer the one with less debt.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free report on analyst forecasts for the company.
Of course Mount Gibson Iron may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE 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 editorial-team@simplywallst.com.
