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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). To keep the lesson grounded in practicality, we'll use ROE to better understand LH Group Limited (HKG:1978).
LH Group has a ROE of 18%, based on the last twelve months. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.18 in profit.
View our latest analysis for LH Group
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for LH Group:
18% = HK$72m ÷ HK$402m (Based on the trailing twelve months to June 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does LH Group 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, LH Group has a higher ROE than the average (8.0%) in the Hospitality 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.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), 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 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.
LH Group's Debt And Its 18% ROE
LH Group is free of net debt, which is a positive for shareholders. Its ROE already suggests it is a good business, but the fact it has achieved this -- and doesn't borrowings -- makes it worthy of further consideration, in my view. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.