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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Dali Foods Group Company Limited (HKG:3799).

Over the last twelve months Dali Foods Group has recorded a ROE of 25%. That means that for every HK$1 worth of shareholders’ equity, it generated HK$0.25 in profit.

See our latest analysis for Dali Foods Group

How Do I Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Dali Foods Group:

25% = 3648.783 ÷ CN¥15b (Based on the trailing twelve months to June 2018.)

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

What Does ROE Signify?

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

Does Dali Foods 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, Dali Foods Group has a higher ROE than the average (11%) in the food industry.

That’s what I like to see. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .

Why You Should Consider Debt When Looking At ROE

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 two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.