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 Jerash Holdings (US), Inc. (NASDAQ:JRSH), by way of a worked example.
Over the last twelve months Jerash Holdings (US) has recorded a ROE of 12%. Another way to think of that is that for every $1 worth of equity in the company, it was able to earn $0.12.
How Do I Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Jerash Holdings (US):
12% = US$6.6m ÷ US$54m (Based on the trailing twelve months to September 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE 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, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does Jerash Holdings (US) 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. 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 Jerash Holdings (US) has an ROE that is fairly close to the average for the Luxury industry (12%).
That's not overly surprising. 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. For those who like to find winning investments this free list of growing companies with recent insider purchasing, could be just the ticket.
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their 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 debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Jerash Holdings (US)'s Debt And Its 12% ROE
Jerash Holdings (US) has a debt to equity ratio of just 0.00029, which is very low. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
The Bottom Line On ROE
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 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 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.
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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. Thank you for reading.