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 Huaibei GreenGold Industry Investment Co., Ltd. (HKG:2450), by way of a worked example.
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
Check out our latest analysis for Huaibei GreenGold Industry Investment
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Huaibei GreenGold Industry Investment is:
3.6% = CN¥23m ÷ CN¥648m (Based on the trailing twelve months to June 2024).
The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.04 in profit.
Does Huaibei GreenGold Industry Investment 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. You can see in the graphic below that Huaibei GreenGold Industry Investment has an ROE that is fairly close to the average for the Basic Materials industry (3.1%).
That's neither particularly good, nor bad. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If true, then it is more an indication of risk than the potential. You can see the 4 risks we have identified for Huaibei GreenGold Industry Investment by visiting our risks dashboard for free on our platform here.
How Does Debt Impact Return On Equity?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing shares, retained earnings, 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Huaibei GreenGold Industry Investment's Debt And Its 3.6% ROE
It's worth noting the high use of debt by Huaibei GreenGold Industry Investment, leading to its debt to equity ratio of 2.39. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
Summary
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.
But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. Check the past profit growth by Huaibei GreenGold Industry Investment by looking at this visualization of past earnings, revenue and cash flow.
Of course Huaibei GreenGold Industry Investment may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.