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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 China Evergrande Group (HKG:3333), by way of a worked example.
Our data shows China Evergrande Group has a return on equity of 21% for the last year. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.21.
View our latest analysis for China Evergrande Group
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for China Evergrande Group:
21% = 36343 ÷ CN¥325b (Based on the trailing twelve months to June 2018.)
It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE 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. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does China Evergrande Group Have A Good ROE?
By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, China Evergrande Group has a higher ROE than the average (9.7%) in the Real Estate industry.
That’s what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
Why You Should Consider Debt When Looking At ROE
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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.