Is Lenovo Group Limited (HKG:992) A High Quality Stock To Own?

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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Lenovo Group Limited (HKG:992).

Lenovo Group has a ROE of 21%, based on the last twelve months. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.21 in profit.

See our latest analysis for Lenovo Group

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Lenovo Group:

21% = US$715m ÷ US$4.0b (Based on the trailing twelve months to September 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. 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 Signify?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does Lenovo Group Have A Good ROE?

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. Pleasingly, Lenovo Group has a superior ROE than the average (8.2%) company in the Tech industry.

That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.

The Importance Of Debt To 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 debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining Lenovo Group's Debt And Its 21% Return On Equity

Lenovo Group clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.19. Its ROE is quite good but, it would have probably been lower without the use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

In Summary

Return on equity is one way we can compare the business quality of different companies. 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 ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 you might want to check this FREE visualization of analyst forecasts for the company.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss thisfree list of interesting companies, that have HIGH return on equity and low debt.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.