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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of China Infrastructure & Logistics Group Ltd. (HKG:1719).
Over the last twelve months China Infrastructure & Logistics Group has recorded a ROE of 8.4%. One way to conceptualize this, is that for each HK$1 of shareholders' equity it has, the company made HK$0.084 in profit.
How Do I Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for China Infrastructure & Logistics Group:
8.4% = HK$63m ÷ HK$784m (Based on the trailing twelve months to June 2019.)
It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. 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 Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does China Infrastructure & Logistics 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. If you look at the image below, you can see China Infrastructure & Logistics Group has a similar ROE to the average in the Infrastructure industry classification (9.8%).
That isn't amazing, but it is respectable. ROE doesn't tell us if the share price is low, but it can inform us to the nature of the business. For those looking for a bargain, other factors may be more important. I will like China Infrastructure & Logistics 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.
Why You Should Consider Debt When Looking At ROE
Virtually all companies need money to invest in the business, to grow 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 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.
China Infrastructure & Logistics Group's Debt And Its 8.4% ROE
While China Infrastructure & Logistics Group does have some debt, with debt to equity of just 0.63, we wouldn't say debt is 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.
Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.
Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow .
Of course China Infrastructure & Logistics Group 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.
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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. Thank you for reading.