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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 Grand Pharmaceutical and Healthcare Holdings Limited (HKG:512), by way of a worked example.
China Grand Pharmaceutical and Healthcare Holdings has a ROE of 12%, based on the last twelve months. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.12 in profit.
Check out our latest analysis for China Grand Pharmaceutical and Healthcare Holdings
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for China Grand Pharmaceutical and Healthcare Holdings:
12% = HK$954m ÷ HK$8.2b (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 all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Mean?
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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does China Grand Pharmaceutical and Healthcare Holdings 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. You can see in the graphic below that China Grand Pharmaceutical and Healthcare Holdings has an ROE that is fairly close to the average for the Pharmaceuticals industry (13%).
That isn't amazing, but it is respectable. ROE doesn't tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. I will like China Grand Pharmaceutical and Healthcare Holdings better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.