One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning-by-doing, we’ll take a look at the ROE to better understand Home Control International Limited (HKG: 1747).
Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. In simpler terms, it measures a company’s profitability relative to equity.
Discover our latest analyzes for Home Control International
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of Home Control International is:
19% = US $ 3.7 million US $ 19 million (based on the last twelve months to December 2020).
The “return” is the amount earned after tax over the past twelve months. Another way to look at this is that for every HK $ 1 worth of shares, the company was able to make HK $ 0.19 in profit.
Does Home Control International have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average for its industry. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As you can see in the graph below, Home Control International has a higher than average ROE (14%) in the durable consumer goods sector.
This is what we love to see. That said, high ROE doesn’t always indicate high profitability. Especially when a business uses high levels of leverage to finance its debt, which can increase its ROE but high leverage puts the business at risk. Our risk dashboards must include the 4 risks that we have identified for Home Control International.
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 issuance of 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 used for growth will improve returns, but will not affect total equity. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
Home Control International’s debt and its ROE of 19%
Home Control International is clearly using a high amount of debt to increase its returns, as its debt-to-equity ratio is 1.42. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. Debt increases risk and reduces options for the business in the future, so you generally want to get good returns using it.
Return on equity is one way we can compare the quality of business of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
That said, while ROE is a useful indicator of how good a business is, you will need to look at a variety of factors to determine the right price to buy a stock. It’s important to take other factors into account, such as future profit growth – and the amount of investment needed in the future. You might want to check out this FREE visualization of analyst forecasts for the business.
Of course Home Control International may not be the best stock to buy. So you might want to see this free collects other companies that have high ROE and low debt.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, 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 information. Simply Wall St has no position in any of the stocks mentioned.
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