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). By way of learning-by-doing, we’ll look at ROE to gain a better understanding Longfor Group Holdings Limited (HKG:960).

Over the last twelve months Longfor Group Holdings has recorded a ROE of 15%. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.15.

Check out our latest analysis for Longfor Group Holdings

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Longfor Group Holdings:

15% = CN¥13.6b ÷ CN¥120.4b (Based on the trailing twelve months to June 2018.)

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. 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?

Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the yearly profit. A higher profit will lead to a 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 Longfor Group 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Longfor Group Holdings has a better ROE than the average (9.3%) in the real estate industry.

That is a good sign. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.

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 and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.