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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 BOC Aviation Limited (HKG:2588), by way of a worked example.
Over the last twelve months BOC Aviation 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.
View our latest analysis for BOC Aviation
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for BOC Aviation:
15% = US$645m ÷ US$4.3b (Based on the trailing twelve months to June 2019.)
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. 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 yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does BOC Aviation 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. 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, BOC Aviation has a better ROE than the average (7.9%) in the Trade Distributors industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares.
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 and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
BOC Aviation's Debt And Its 15% ROE
It appears that BOC Aviation makes extensive use of debt to improve its returns, because it has a relatively high debt to equity ratio of 3.06. Its ROE is decent, but once I consider all the debt, I'm not really impressed.