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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 LKS Holding Group Limited (HKG:8415), by way of a worked example.
LKS Holding Group has a ROE of 21%, 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$0.21 in profit.
See our latest analysis for LKS Holding Group
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for LKS Holding Group:
21% = 22.971 ÷ HK$107m (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 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 ROE Mean?
ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the amount earned after tax over the last twelve months. 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 ROE can be used to compare two businesses.
Does LKS Holding Group Have A Good ROE?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, LKS Holding Group has a better ROE than the average (11%) in the Commercial Services industry.
That is a good sign. 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.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. That will make the ROE look better than if no debt was used.