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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 Hebei Construction Group Corporation Limited (HKG:1727), by way of a worked example.
Over the last twelve months Hebei Construction Group has recorded a ROE of 20%. That means that for every HK$1 worth of shareholders’ equity, it generated HK$0.20 in profit.
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Hebei Construction Group:
20% = CN¥1.1b ÷ CN¥5.7b (Based on the trailing twelve months to December 2018.)
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?
Return on Equity measures a company’s profitability against the profit it has kept for the business (plus any capital injections). The ‘return’ is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does Hebei Construction Group Have A Good Return On Equity?
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 is clear from the image below, Hebei Construction Group has a better ROE than the average (11%) in the Construction industry.
That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. 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. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.
Hebei Construction Group’s Debt And Its 20% ROE
While Hebei Construction Group does have some debt, with debt to equity of just 0.61, we wouldn’t say debt is excessive. 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.
The Key Takeaway
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 the same ROE, then I would generally prefer the one with less debt.
But when a business is high quality, the market often bids it up to a price that reflects this. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow .
But note: Hebei Construction Group may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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. Thank you for reading.