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 Lumina Group Limited (HKG:8470).
Our data shows Lumina Group has a return on equity of 12% for the last year. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.12.
View our latest analysis for Lumina Group
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Lumina Group:
12% = HK$12m ÷ HK$97m (Based on the trailing twelve months to June 2018.)
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. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. A higher profit will lead to a a higher ROE. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Lumina Group 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. As is clear from the image below, Lumina Group has a better ROE than the average (9.8%) in the commercial services industry.
That is a good sign. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.
Lumina Group’s Debt And Its 12% ROE
Shareholders will be pleased to learn that Lumina Group has not one iota of net debt! 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.