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 will look at the ROE to better understand MEGAIN Holding (Cayman) Co., Ltd. (HKG: 6939).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
See our latest analysis for MEGAIN Holding (Cayman)
How is the ROE calculated?
Return on equity can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of MEGAIN Holding (Cayman) is:
17% = CN ¥ 29m CN ¥ 174m (Based on the last twelve months up to December 2020).
The “return” is the profit of the last twelve months. So this means that for every HK $ 1 invested by its shareholder, the company generates a profit of HK $ 0.17.
Does MEGAIN Holding (Cayman) have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industry classification. Fortunately, MEGAIN Holding (Cayman) has an above-average ROE (8.6%) for the semiconductor industry.
It’s a good sign. 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. To find out about the 2 risks that we have identified for MEGAIN Holding (Caïman), visit our risk dashboard free of charge.
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 (equity) or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. 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.
The debt of MEGAIN Holding (Cayman) and its ROE of 17%
MEGAIN Holding (Cayman) is net debt free, which is positive for shareholders. Its ROE suggests that this is a decent business; and the fact that it does not mine returns indicates that it is worth watching. After all, when a business has a strong balance sheet, it can often find ways to invest in growth, even if it takes a while.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
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. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You can see how the business has grown in the past by checking out 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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This Simply Wall St article is general in nature. 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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