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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of CDL Hospitality Trusts (SGX:J85).

Our data shows CDL Hospitality Trusts has a return on equity of 5.3% for the last year. One way to conceptualize this, is that for each SGD1 of shareholders' equity it has, the company made SGD0.05 in profit.

View our latest analysis for CDL Hospitality Trusts

How Do I Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for CDL Hospitality Trusts:

5.3% = S$95m ÷ S$1.8b (Based on the trailing twelve months to June 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.

What Does ROE 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. 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. That means ROE can be used to compare two businesses.

Does CDL Hospitality Trusts 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. The image below shows that CDL Hospitality Trusts has an ROE that is roughly in line with the REITs industry average (6.2%).

That isn't amazing, but it is respectable. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.