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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 Longfor Group Holdings Limited (HKG:960).
Longfor Group Holdings has a ROE of 15%, based on the last twelve months. One way to conceptualize this, is that for each HK$1 of shareholders' equity it has, the company made HK$0.15 in profit.
Check out our latest analysis for Longfor Group Holdings
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Longfor Group Holdings:
15% = CN¥16b ÷ CN¥141b (Based on the trailing twelve months to December 2018.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. 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 Return On Equity 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. A higher profit will lead to a higher ROE. 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 Longfor Group 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, Longfor Group Holdings has a superior ROE than the average (9.1%) company in the Real Estate industry.
That's clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.
How Does Debt Impact Return On Equity?
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 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.