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 China Everbright Greentech Limited (HKG:1257), by way of a worked example.
Our data shows China Everbright Greentech has a return on equity of 15% for the last year. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.15.
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for China Everbright Greentech:
15% = HK$1.5b ÷ HK$10b (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. 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 Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does China Everbright Greentech 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. Pleasingly, China Everbright Greentech has a superior ROE than the average (8.2%) company in the Renewable Energy industry.
That’s what I like to see. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares.
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 issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.