In This Article:
One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we'll use ROE to better understand China Aoyuan Group Limited (HKG:3883).
Over the last twelve months China Aoyuan Group has recorded a ROE of 12%. One way to conceptualize this, is that for each HK$1 of shareholders' equity it has, the company made HK$0.12 in profit.
Check out our latest analysis for China Aoyuan Group
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for China Aoyuan Group:
12% = CN¥3.5b ÷ CN¥35b (Based on the trailing twelve months to June 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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity 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 amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does China Aoyuan 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. 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, China Aoyuan Group has a better ROE than the average (8.6%) in the Real Estate industry.
That's clearly a positive. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.
How Does Debt Impact ROE?
Most companies need money -- from somewhere -- 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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.
China Aoyuan Group's Debt And Its 12% ROE
It's worth noting the significant use of debt by China Aoyuan Group, leading to its debt to equity ratio of 2.23. There's no doubt the ROE is respectable, but it's worth keeping in mind that metric is elevated by 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.