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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. We’ll use ROE to examine Tsui Wah Holdings Limited (HKG:1314), by way of a worked example.
Our data shows Tsui Wah Holdings has a return on equity of 4.2% for the last year. One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.042 in profit.
See our latest analysis for Tsui Wah Holdings
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Tsui Wah Holdings:
4.2% = 46.606 ÷ HK$1.1b (Based on the trailing twelve months to September 2018.)
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 earnings retained by the company, plus any capital paid in by shareholders. 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 Tsui Wah 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 shown in the graphic below, Tsui Wah Holdings has a lower ROE than the average (6.9%) in the hospitality industry classification.
That certainly isn’t ideal. 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.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. That will make the ROE look better than if no debt was used.