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 Kimou Environmental Holding Limited (HKG:6805), 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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
How Is ROE Calculated?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Kimou Environmental Holding is:
7.3% = CN¥85m ÷ CN¥1.2b (Based on the trailing twelve months to December 2020).
The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each HK$1 of shareholders' capital it has, the company made HK$0.07 in profit.
Does Kimou Environmental Holding 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Kimou Environmental Holding has a lower ROE than the average (10%) in the Commercial Services industry.
That's not what we like to see. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their 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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
Combining Kimou Environmental Holding's Debt And Its 7.3% Return On Equity
Kimou Environmental Holding clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.07. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Return on equity is one way we can compare its business quality of different companies. In our books, 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. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. 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.
But note: Kimou Environmental Holding 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.
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