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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine China Aviation Oil (Singapore) Corporation Ltd (SGX:G92), by way of a worked example.
China Aviation Oil (Singapore) has a ROE of 12%, based on the last twelve months. That means that for every SGD1 worth of shareholders' equity, it generated SGD0.12 in profit.
See our latest analysis for China Aviation Oil (Singapore)
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for China Aviation Oil (Singapore):
12% = US$92m ÷ US$793m (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 all the money paid into the company from shareholders, plus any earnings retained. 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?
ROE looks at the amount a company earns relative to the money it has kept within the business. 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 China Aviation Oil (Singapore) Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that China Aviation Oil (Singapore) has an ROE that is roughly in line with the Oil and Gas industry average (12%).
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.
Why You Should Consider Debt When Looking At ROE
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.