In This Article:
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 Smart-Core Holdings Limited (HKG:2166), by way of a worked example.
Our data shows Smart-Core Holdings has a return on equity of 14% for the last year. That means that for every HK$1 worth of shareholders’ equity, it generated HK$0.14 in profit.
See our latest analysis for Smart-Core Holdings
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Smart-Core Holdings:
14% = 72.707445 ÷ HK$537m (Based on the trailing twelve months to June 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does Return On Equity Mean?
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 yearly profit. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Smart-Core Holdings 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. 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, Smart-Core Holdings has a higher ROE than the average (11%) in the Electronic industry.
That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Smart-Core Holdings’s Debt And Its 14% Return On Equity
Smart-Core Holdings has a debt to equity ratio of 0.17, which is far from excessive. The combination of modest debt and a very respectable ROE suggests this is a business worth watching. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.