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. We'll use ROE to examine C.I. Holdings Berhad (KLSE:CIHLDG), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Simply put, it is used to assess the profitability of a company in relation to its equity capital.
Check out our latest analysis for C.I. Holdings Berhad
How Is ROE Calculated?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for C.I. Holdings Berhad is:
28% = RM127m ÷ RM450m (Based on the trailing twelve months to September 2022).
The 'return' is the income the business earned over the last year. That means that for every MYR1 worth of shareholders' equity, the company generated MYR0.28 in profit.
Does C.I. Holdings Berhad 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. As you can see in the graphic below, C.I. Holdings Berhad has a higher ROE than the average (11%) in the Food industry.
That's clearly a positive. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . Our risks dashboardshould have the 2 risks we have identified for C.I. Holdings Berhad.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow 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.
C.I. Holdings Berhad's Debt And Its 28% ROE
It's worth noting the high use of debt by C.I. Holdings Berhad, leading to its debt to equity ratio of 1.09. Its ROE is pretty impressive but, it would have probably been lower without the use of debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.