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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). To keep the lesson grounded in practicality, we’ll use ROE to better understand Cteh Inc. (
HKG:1620
).
Over the last twelve months
Cteh has recorded a ROE of 5.7%
. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.057.
See our latest analysis for Cteh
How Do I Calculate Return On Equity?
The
formula for ROE
is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Cteh:
5.7% = 8.748 ÷ HK$153m (Based on the trailing twelve months to June 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 ROE Signify?
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 yearly profit. That means that the higher the ROE, the more profitable the company is. So, as a general rule,
a high ROE is a good thing
. Clearly, then, one can use ROE to compare different companies.
Does Cteh 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. The image below shows that Cteh has an ROE that is roughly in line with the Hospitality industry average (6.8%).
SEHK:1620 Last Perf February 1st 19
That isn’t amazing, but it is respectable. ROE doesn’t tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. If you like to buy stocks alongside management, then you might just love this
free
list of companies. (Hint: insiders have been buying them).
Why You Should Consider Debt When Looking At ROE
Most companies need money — from somewhere — to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Story continues
Combining Cteh’s Debt And Its 5.7% Return On Equity
While Cteh does have some debt, with debt to equity of just 0.23, we wouldn’t say debt is excessive. Its ROE isn’t particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. 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 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. All else being equal, a higher ROE is better.
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. 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
.
Of course,
you might find a fantastic investment by looking elsewhere.
So take a peek at this
free
list of interesting companies.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at
.
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