Based On Its ROE, Is Shenma Industry Co.Ltd (SHSE:600810) A High Quality Stock?

Simply Wall St · 10/17 22:14

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 Shenma Industry Co.Ltd (SHSE:600810), by way of a worked example.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Shenma IndustryLtd

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 Shenma IndustryLtd is:

2.6% = CN¥303m ÷ CN¥12b (Based on the trailing twelve months to June 2024).

The 'return' is the profit over the last twelve months. So, this means that for every CN¥1 of its shareholder's investments, the company generates a profit of CN¥0.03.

Does Shenma IndustryLtd Have A Good Return On Equity?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Shenma IndustryLtd has a lower ROE than the average (6.4%) in the Chemicals industry.

roe
SHSE:600810 Return on Equity October 17th 2024

That certainly isn't ideal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. Our risks dashboard should have the 3 risks we have identified for Shenma IndustryLtd.

How Does Debt Impact ROE?

Virtually all companies need money to invest in the business, to grow 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining Shenma IndustryLtd's Debt And Its 2.6% Return On Equity

Shenma IndustryLtd clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.35. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. 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.

Summary

Return on equity is one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course Shenma IndustryLtd 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.