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). We’ll use ROE to examine Tianjin Development Holdings Limited (HKG:882), by way of a worked example.

Tianjin Development Holdings has a ROE of 3.3%, based on the last twelve months. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.033.

View our latest analysis for Tianjin Development Holdings

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Tianjin Development Holdings:

3.3% = HK$426m ÷ HK$16.5b (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 ROE Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a a higher ROE. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.

Does Tianjin Development Holdings Have A Good Return On Equity?

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 shown in the graphic below, Tianjin Development Holdings has a lower ROE than the average (11%) in the integrated utilities industry classification.

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 might be wise to check if insiders have been selling.

Why You Should Consider Debt When Looking At ROE

Companies usually need to invest money to grow their 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 required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.