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). To keep the lesson grounded in practicality, we’ll use ROE to better understand Kingworld Medicines Group Limited (HKG:1110).

Kingworld Medicines Group has a ROE of 11%, based on the last twelve months. One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.11 in profit.

Check out our latest analysis for Kingworld Medicines Group

How Do I Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Kingworld Medicines Group:

11% = CN¥56m ÷ CN¥634m (Based on the trailing twelve months to June 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. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.

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

Does Kingworld Medicines 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, Kingworld Medicines Group has a higher ROE than the average (7.6%) in the healthcare industry.

That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .

The Importance Of Debt To Return On Equity

Most companies need money — from somewhere — 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.