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 ZH International Holdings Limited (HKG:185), by way of a worked example.
ZH International Holdings has a ROE of 2.5%, based on the last twelve months. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.025.
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for ZH International Holdings:
2.5% = CN¥30m ÷ CN¥1.1b (Based on the trailing twelve months to December 2018.)
Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. 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 ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the yearly profit. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does ZH International Holdings Have A Good ROE?
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. As is clear from the image below, ZH International Holdings has a lower ROE than the average (9.1%) in the Real Estate industry.
Unfortunately, that’s sub-optimal. We prefer it when the ROE of a company is above the industry average, but it’s not the be-all and end-all if it is lower. Nonetheless, it might be wise to check if insiders have been selling.
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 required for growth will boost returns, but will not impact the shareholders’ equity. That will make the ROE look better than if no debt was used.
ZH International Holdings’s Debt And Its 2.5% ROE
We think ZH International Holdings uses a lot of debt to boost returns, as it has a relatively high debt to equity ratio of 22.96. We consider it to be a negative sign when a company has a rather low ROE despite rather high debt to equity.
The Bottom Line On ROE
Return on equity is useful for comparing the quality of different businesses. 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.
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. 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. Check the past profit growth by ZH International Holdings by looking at this visualization of past earnings, revenue and cash flow.
Of course ZH International 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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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.