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. We'll use ROE to examine Vallianz Holdings Limited (Catalist:WPC), by way of a worked example.

Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

View our latest analysis for Vallianz Holdings

How Is ROE Calculated?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Vallianz Holdings is:

14% = US$3.2m ÷ US$23m (Based on the trailing twelve months to June 2024).

The 'return' refers to a company's earnings over the last year. That means that for every SGD1 worth of shareholders' equity, the company generated SGD0.14 in profit.

Does Vallianz Holdings Have A Good Return On Equity?

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, Vallianz Holdings has a higher ROE than the average (9.7%) in the Energy Services industry.

That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 4 risks we have identified for Vallianz Holdings by visiting our risks dashboard for free on our platform here.

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 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.

Vallianz Holdings' Debt And Its 14% ROE

It seems that Vallianz Holdings uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 7.12. Its ROE is pretty good, but given the impact of the debt, we're less than enthused, overall.