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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 Kimou Environmental Holding Limited (HKG:6805), by way of a worked example.
Our data shows Kimou Environmental Holding has a return on equity of 3.9% 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$0.04.
View our latest analysis for Kimou Environmental Holding
How Do I Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Kimou Environmental Holding:
3.9% = CN¥43m ÷ CN¥717m (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 ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.
Does Kimou Environmental Holding 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 shown in the graphic below, Kimou Environmental Holding has a lower ROE than the average (9.3%) in the Commercial Services industry classification.
That certainly isn't ideal. We prefer it when the ROE of a company is above the industry average, but it's not the be-all and end-all if it is lower. Still, shareholders might want to check if insiders have been selling.
How Does Debt Impact Return On Equity?
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 two cases, the ROE will capture this use of capital to grow. 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.
Combining Kimou Environmental Holding's Debt And Its 3.9% Return On Equity
It's worth noting the significant use of debt by Kimou Environmental Holding, leading to its debt to equity ratio of 1.45. Its ROE is quite low, even with the use of significant debt; that's not a good result, in my opinion. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.