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 Health and Happiness (H&H) International Holdings Limited (HKG:1112), by way of a worked example.
Over the last twelve months Health and Happiness (H&H) International Holdings has recorded a ROE of 22%. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.22 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
Or for Health and Happiness (H&H) International Holdings:
22% = CN¥1.2b ÷ CN¥5.2b (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 the capital paid in by shareholders, plus any retained earnings. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.
Does Health and Happiness (H&H) International Holdings Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Health and Happiness (H&H) International Holdings has a better ROE than the average (9.6%) in the Food 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 Return On Equity?
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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.
Combining Health and Happiness (H&H) International Holdings's Debt And Its 22% Return On Equity
Health and Happiness (H&H) International Holdings clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.16. I think the ROE is impressive, but it would have been assisted by the use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using 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. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.
But when a business is high quality, the market often bids it up to a price that reflects this. 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 report on analyst forecasts for the company.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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