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). By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Milestone Builder Holdings Limited (HKG:1667).
Over the last twelve months Milestone Builder Holdings has recorded a ROE of 10%. That means that for every HK$1 worth of shareholders’ equity, it generated HK$0.10 in profit.
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How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Milestone Builder Holdings:
10% = 12.627 ÷ HK$123m (Based on the trailing twelve months to September 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. 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 amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.
Does Milestone Builder Holdings Have A Good Return On Equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that Milestone Builder Holdings has an ROE that is roughly in line with the Construction industry average (12%).
That’s not overly surprising. ROE doesn’t tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
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 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. That will make the ROE look better than if no debt was used.
Milestone Builder Holdings’s Debt And Its 10% ROE
Milestone Builder Holdings has a debt to equity ratio of 0.88, which is far from excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. 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.
But It’s Just One Metric
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In my book the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.