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Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Shanghai Fudan-Zhangjiang Bio-Pharmaceutical Co., Ltd. (HKG:1349), by way of a worked example.
Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a ROE of 16%, based on the last twelve months. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.16 in profit.
See our latest analysis for Shanghai Fudan-Zhangjiang Bio-Pharmaceutical
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Shanghai Fudan-Zhangjiang Bio-Pharmaceutical:
16% = CN¥188m ÷ CN¥1.0b (Based on the trailing twelve months to June 2019.)
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 all the money paid into the company from shareholders, plus any earnings retained. 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?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. 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 Shanghai Fudan-Zhangjiang Bio-Pharmaceutical 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. 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, Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a better ROE than the average (13%) in the Pharmaceuticals industry.
That's clearly a positive. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.