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 KPa-BM Holdings Limited (HKG:2663), by way of a worked example.

Over the last twelve months KPa-BM Holdings has recorded a ROE of 15%. One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.15 in profit.

Check out our latest analysis for KPa-BM Holdings

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for KPa-BM Holdings:

15% = HK$26m ÷ HK$172m (Based on the trailing twelve months to March 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. 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 Return On Equity Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.

Does KPa-BM Holdings 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As you can see in the graphic below, KPa-BM Holdings has a higher ROE than the average (12%) in the construction industry.

That’s what I like to see. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.

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 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining KPa-BM Holdings’s Debt And Its 15% Return On Equity

KPa-BM Holdings has a debt to equity ratio of 0.11, which is far from excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.