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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 Dawnrays Pharmaceutical (Holdings) Limited (HKG:2348).

Over the last twelve months Dawnrays Pharmaceutical (Holdings) has recorded a ROE of 16%. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.16.

Check out our latest analysis for Dawnrays Pharmaceutical (Holdings)

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Dawnrays Pharmaceutical (Holdings):

16% = 310.203 ÷ CN¥1.9b (Based on the trailing twelve months to June 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. 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 Return On Equity 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 profit 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 it can be interesting to compare the ROE of different companies.

Does Dawnrays Pharmaceutical (Holdings) 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. Pleasingly, Dawnrays Pharmaceutical (Holdings) has a superior ROE than the average (13%) company in the Pharmaceuticals industry.

That’s clearly a positive. 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

Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. 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 required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.

Combining Dawnrays Pharmaceutical (Holdings)’s Debt And Its 16% Return On Equity

Dawnrays Pharmaceutical (Holdings) has a debt to equity ratio of just 0.042, which is very low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

But It’s Just One Metric

Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.

But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. Check the past profit growth by Dawnrays Pharmaceutical (Holdings) by looking at this visualization of past earnings, revenue and cash flow.

If you would prefer check out another company — one with potentially superior financials — then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.