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 Techtronic Industries Company Limited (HKG:669), by way of a worked example.

Over the last twelve months Techtronic Industries has recorded a ROE of 18%. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.18 in profit.

Check out our latest analysis for Techtronic Industries

How Do I Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Techtronic Industries:

18% = US$552m ÷ US$3.1b (Based on the trailing twelve months to December 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 Return On Equity Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. 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. Clearly, then, one can use ROE to compare different companies.

Does Techtronic Industries Have A Good Return On Equity?

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, Techtronic Industries has a higher ROE than the average (11%) in the Machinery industry.

That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.

How Does Debt Impact Return On Equity?

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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.