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 Shanghai Fudan-Zhangjiang Bio-Pharmaceutical Co., Ltd. (HKG:1349), by way of a worked example.

Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a ROE of 16%, based on the last twelve months. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.16 in profit.

See our latest analysis for Shanghai Fudan-Zhangjiang Bio-Pharmaceutical

How Do You Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Shanghai Fudan-Zhangjiang Bio-Pharmaceutical:

16% = CN¥188m ÷ CN¥1.0b (Based on the trailing twelve months to June 2019.)

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 all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.

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 yearly profit. The higher the ROE, the more profit the company is making. 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 Shanghai Fudan-Zhangjiang Bio-Pharmaceutical 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a better ROE than the average (13%) in the Pharmaceuticals industry.

That's clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.

How Does Debt Impact Return On Equity?

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 and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

Combining Shanghai Fudan-Zhangjiang Bio-Pharmaceutical's Debt And Its 16% Return On Equity

Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a debt to equity ratio of 0.14, which is far from excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.

The Key Takeaway

Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.

But when a business is high quality, the market often bids it up to a price that reflects this. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.

Of course Shanghai Fudan-Zhangjiang Bio-Pharmaceutical may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.