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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Glory Sun Land Group Limited (HKG:299).
Glory Sun Land Group has a ROE of 10%, based on the last twelve months. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.10 in profit.
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Glory Sun Land Group:
10% = HK$468m ÷ HK$4.6b (Based on the trailing twelve months to December 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 Return On Equity Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. 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 Glory Sun Land Group Have A Good Return On Equity?
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 Glory Sun Land Group has an ROE that is fairly close to the average for the Entertainment industry (12%).
That's neither particularly good, nor bad. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. I will like Glory Sun Land Group better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.
Glory Sun Land Group's Debt And Its 10% ROE
Glory Sun Land Group does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.82. Its ROE is quite good but, it would have probably been lower without the use of debt. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.
But It's Just One Metric
Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.
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. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow.
But note: Glory Sun Land Group may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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