In This Article:
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 Chengtong Development Group Limited (HKG:217), by way of a worked example.
Over the last twelve months China Chengtong Development Group has recorded a ROE of 1.1%. One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.011 in profit.
See our latest analysis for China Chengtong Development Group
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for China Chengtong Development Group:
1.1% = HK$32m ÷ HK$3.0b (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. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
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 profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does China Chengtong Development 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 is clear from the image below, China Chengtong Development Group has a lower ROE than the average (9.7%) in the trade distributors industry.
Unfortunately, that’s sub-optimal. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Nonetheless, it could be useful to double-check if insiders have sold shares recently.
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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.