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 LVGEM (China) Real Estate Investment Company Limited (HKG:95), by way of a worked example.
LVGEM (China) Real Estate Investment has a ROE of 17%, based on the last twelve months. That means that for every HK$1 worth of shareholders’ equity, it generated HK$0.17 in profit.
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
Or for LVGEM (China) Real Estate Investment:
17% = CN¥2.0b ÷ CN¥12b (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 the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its 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 amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does LVGEM (China) Real Estate Investment Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in 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 you can see in the graphic below, LVGEM (China) Real Estate Investment has a higher ROE than the average (8.4%) in the Real Estate industry.
That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
Why You Should Consider Debt When Looking At ROE
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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining LVGEM (China) Real Estate Investment’s Debt And Its 17% Return On Equity
It’s worth noting the significant use of debt by LVGEM (China) Real Estate Investment, leading to its debt to equity ratio of 1.95. Its ROE is quite good but, it would have probably been lower without the use of debt. Debt does bring extra risk, so it’s only really worthwhile when a company generates some decent returns from it.
The Key Takeaway
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. 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.
Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. Check the past profit growth by LVGEM (China) Real Estate Investment by looking at this visualization of past earnings, revenue and cash flow.
Of course LVGEM (China) Real Estate Investment 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 email@example.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.
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