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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 Railway Signal & Communication Corporation Limited (HKG:3969), by way of a worked example.

Our data shows China Railway Signal & Communication has a return on equity of 13% for the last year. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.13 in profit.

Check out our latest analysis for China Railway Signal & Communication

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for China Railway Signal & Communication:

13% = CN¥3.5b ÷ CN¥30b (Based on the trailing twelve months to March 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 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 Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.

Does China Railway Signal & Communication Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, China Railway Signal & Communication has a superior ROE than the average (9.8%) company in the Electronic industry.

That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.

How Does Debt Impact 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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

Combining China Railway Signal & Communication's Debt And Its 13% Return On Equity

While China Railway Signal & Communication does have a tiny amount of debt, with debt to equity of just 0.076, we think the use of debt is very modest. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.

The Key Takeaway

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.

Of course China Railway Signal & Communication may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.