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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Ping An Insurance (Group) Company of China, Ltd. (HKG:2318).
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
Check out our latest analysis for Ping An Insurance (Group) Company of China
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Ping An Insurance (Group) Company of China is:
19% = CN¥164b ÷ CN¥852b (Based on the trailing twelve months to December 2019).
The 'return' is the income the business earned over the last year. That means that for every HK$1 worth of shareholders' equity, the company generated HK$0.19 in profit.
Does Ping An Insurance (Group) Company of China Have A Good ROE?
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. Pleasingly, Ping An Insurance (Group) Company of China has a superior ROE than the average (13%) in the Insurance industry.
That is a good sign. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. To know the 3 risks we have identified for Ping An Insurance (Group) Company of China visit our risks dashboard for free.
How Does Debt Impact ROE?
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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.