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. To keep the lesson grounded in practicality, we will use ROE to better understand Zhejiang Expressway Co., Ltd. (HKG: 576).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
Check out our latest analysis for the Zhejiang Highway
How is the ROE calculated?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE of Zhejiang Expressway is:
16% = CN ¥ 6.6b ÷ CN ¥ 41b (Based on the last twelve months up to June 2021).
The “return” is the amount earned after tax over the past twelve months. So this means that for every HK $ 1 invested by its shareholder, the company generates a profit of HK $ 0.16.
Does Zhejiang Highway Have a Good Return on Equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. As you can see in the graph below, the Zhejiang Expressway has an above-average ROE (9.3%) for the infrastructure sector.
This is clearly positive. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk.
What is the impact of debt on return on equity?
Almost all businesses need money to invest in the business, to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) or debt. In the first and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the debt necessary for growth will increase returns, but will have no impact on equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Combine Zhejiang Expressway Debt and 16% Return on Equity
The Zhejiang Highway uses a large amount of debt to increase yields. Its debt ratio is 1.69. While his ROE is quite respectable, the amount of debt the company currently carries is not ideal. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. A business that can earn a high return on equity without going into debt could be considered a high quality business. All other things being equal, a higher ROE is better.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So you might want to check out this FREE visualization of analyst forecasts for the business.
Sure, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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