One of the best investments we can make is meadowbrook camping area photosin 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 Success Universe Group Limited (

HKG:487

), by way of a worked example.

Over the last twelve months

Success Universe Group has recorded a ROE of 4.0%

. One way to conceptualize this, is that for each HK$1 of shareholders’ equity it has, the company made HK$0.040 in profit.

View our latest analysis for Success Universe Group

How Do You Calculate ROE?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Success Universe Group:

4.0% = 42.573 ÷ HK$1.0b (Based on the trailing twelve months to June 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does Return On Equity Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the profit 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

. Clearly, then, one can use ROE to compare different companies.

Does Success Universe Group Have A Good ROE?

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. As is clear from the image below, Success Universe Group has a lower ROE than the average (6.9%) in the Hospitality industry.

SEHK:487 Last Perf January 2nd 19

Unfortunately, that’s sub-optimal. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Still,

shareholders might want to check if insiders have been selling

.

Why You Should Consider Debt When Looking At ROE

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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Story continues

Success Universe Group’s Debt And Its 4.0% ROE

While Success Universe Group does have some debt, with debt to equity of just 0.14, we wouldn’t say debt is excessive. Its ROE is quite low, and the company already has some debt, so surely shareholders are hoping for an improvement. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company’s ability to take advantage of future opportunities.

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. If two companies have the same ROE, then I would generally prefer the one with less debt.

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

this

detailed graph

of past earnings, revenue and cash flow

.

Of course

Success Universe 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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at

[email protected]

.

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