Is Ching Lee Holdings Limited's (HKG:3728) ROE Of 11% Impressive?

By
Simply Wall St
Published
May 27, 2021
SEHK:3728
Source: Shutterstock

While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Ching Lee Holdings Limited (HKG:3728), by way of a worked example.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for Ching Lee Holdings

How Is ROE Calculated?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Ching Lee Holdings is:

11% = HK$14m ÷ HK$132m (Based on the trailing twelve months to September 2020).

The 'return' is the profit over the last twelve months. So, this means that for every HK$1 of its shareholder's investments, the company generates a profit of HK$0.11.

Does Ching Lee Holdings 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. As is clear from the image below, Ching Lee Holdings has a better ROE than the average (8.5%) in the Construction industry.

roe
SEHK:3728 Return on Equity May 28th 2021

That's what we like to see. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. Our risks dashboardshould have the 5 risks we have identified for Ching Lee Holdings.

The Importance Of Debt To Return On Equity

Most companies need money -- from somewhere -- to grow their 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 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.

Ching Lee Holdings' Debt And Its 11% ROE

Ching Lee Holdings clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.19. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

Summary

Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. 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 when a business is high quality, the market often bids it up to a price that reflects this. 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 Ching Lee Holdings by looking at this visualization of past earnings, revenue and cash flow.

Of course Ching Lee Holdings 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.

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