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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 Tu Yi Holding Company Limited (HKG:1701), by way of a worked example.
Over the last twelve months Tu Yi Holding has recorded a ROE of 10%. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.10 in profit.
See our latest analysis for Tu Yi Holding
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Tu Yi Holding:
10% = CN¥24m ÷ CN¥237m (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 the money paid into the company from shareholders, plus any earnings retained. 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 Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. 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 it can be interesting to compare the ROE of different companies.
Does Tu Yi Holding Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Tu Yi Holding has a higher ROE than the average (8.0%) in the Hospitality industry.
That's what I like to see. 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?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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.
Tu Yi Holding's Debt And Its 10% ROE
Although Tu Yi Holding does use debt, its debt to equity ratio of 0.44 is still low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.