While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. As a learning-by-doing, we’ll take a look at the ROE to better understand Canggang Railway Limited (HKG: 2169).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check out our latest review for Canggang Railway
How do you calculate return on equity?
the return on equity formula is:
Return on equity = Net income (from continuing operations) Ã· Equity
So, based on the above formula, the ROE of Canggang Railway is:
8.4% = 65m CN Â¥ Ã· 770m CN Â¥ (based on the last twelve months up to December 2020).
The âreturnâ is the amount earned after tax over the past twelve months. Another way to think about this is that for every HK $ 1 worth of equity, the company was able to earn HK $ 0.08 in profit.
Does Canggang Railway have a good return on equity?
An easy way to determine if a business is having a good return on equity is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ a little within the same industry classification. As you can see in the graph below, Canggang Railway has a higher than average ROE (6.8%) in the transportation industry.
This is clearly positive. Keep in mind that a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels can represent a huge risk. Our risk dashboards should include the 2 risks we have identified for Canggang Railway.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to grow their profits. The money to invest can come from the previous year’s profits (retained earnings), from the issuance of new shares, or from borrowing. 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 will not affect total equity. This will make the ROE better than if no debt was used.
Combination of Canggang Railway debt and 8.4% return on equity
Although Canggang Railway is in debt, with a debt-to-equity ratio of just 0.59, we wouldn’t say the debt is excessive. I’m not impressed with their ROE, but the debt levels aren’t too high, indicating the company has a decent outlook. The prudent use of debt to increase returns is generally a good move for shareholders, even if it leaves the company more exposed to interest rate hikes.
Return on equity is one way we can compare the quality of business of different companies. A business that can earn a high return on equity without debt could be considered a high quality business. All other things being equal, a higher ROE is preferable.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a variety of factors to determine the right price to buy a stock. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. You can see how the business has grown in the past by watching this FREE detailed graphic past earnings, income and cash flow.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a high return on equity and low leverage.
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