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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 Tibet Water Resources Ltd. (HKG:1115), by way of a worked example.
Tibet Water Resources has a ROE of 9.2%, based on the last twelve months. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.092.
See our latest analysis for Tibet Water Resources
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Tibet Water Resources:
9.2% = CN¥318m ÷ CN¥3.5b (Based on the trailing twelve months to December 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. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does ROE Signify?
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 amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.
Does Tibet Water Resources Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in 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 you can see in the graphic below, Tibet Water Resources has a higher ROE than the average (5.2%) in the Beverage industry.
That is a good sign. 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 .
How Does Debt Impact 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 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 Tibet Water Resources's Debt And Its 9.2% Return On Equity
Tibet Water Resources has a debt to equity ratio of 0.33, which is far from excessive. I'm not impressed with its ROE, but the debt levels are not too high, indicating the business has decent prospects. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.