Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

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. To keep the lesson grounded in practicality, we'll use ROE to better understand Beijing Enterprises Water Group Limited (HKG:371).

Over the last twelve months Beijing Enterprises Water Group has recorded a ROE of 14%. One way to conceptualize this, is that for each HK$1 of shareholders' equity it has, the company made HK$0.14 in profit.

View our latest analysis for Beijing Enterprises Water Group

How Do I Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Beijing Enterprises Water Group:

14% = HK$4.5b ÷ HK$38b (Based on the trailing twelve months to December 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is the capital paid in by shareholders, plus any retained earnings. 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 profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.

Does Beijing Enterprises Water Group Have A Good ROE?

Arguably the easiest way to assess company's ROE is to compare it with the average in 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 you can see in the graphic below, Beijing Enterprises Water Group has a higher ROE than the average (8.8%) in the Water Utilities 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 ROE?

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 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. That will make the ROE look better than if no debt was used.