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 Huaxi Holdings Company Limited (HKG:1689), by way of a worked example.

Over the last twelve months Huaxi Holdings has recorded a ROE of 9.4%. One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.094 in profit.

Check out our latest analysis for Huaxi Holdings

How Do You Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Huaxi Holdings:

9.4% = HK$32m ÷ HK$334m (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 earnings retained by the company, plus any capital paid in by shareholders. 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?

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. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does Huaxi Holdings Have A Good ROE?

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. If you look at the image below, you can see Huaxi Holdings has a lower ROE than the average (13%) in the packaging industry classification.

That’s not what we like to see. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to check if insiders have been selling.

The Importance Of Debt To Return On Equity

Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.