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 Luye Pharma Group Ltd. (HKG: 2186).

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. Simply put, it is used to assess a company’s profitability against its equity.

Discover our latest analyzes for Luye Pharma Group

How to calculate return on equity?

the return on equity formula is:

Return on equity = Net income (from continuing operations) ÷ Equity

Thus, on the basis of the above formula, the ROE of the Luye Pharma group is:

8.7% = CNY 703 million ÷ CNY 8.1 billion (based on the last twelve months up to December 2020).

The “return” is the annual profit. One way to conceptualize this is that for every Hong Kong dollar of equity capital it has, the company made a profit of 0.09 Hong Kong dollars.

Does the Luye Pharma group 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. If you look at the image below, you can see that Luye Pharma Group has an ROE similar to the pharmaceutical industry classification average (10%).

SEHK: Return on equity 2186 May 30, 2021

It’s no wonder, but it’s respectable. Although at least the ROE is not lower than that of the industry, it is still worth checking the role of corporate debt, as high levels of debt compared to equity can also make seem high ROE. If this is true, then it is more an indication of risk than potential. To find out about the 3 risks that we have identified for the Luye Pharma Group, visit our risk dashboard for free.

Why You Should Consider Debt When Looking At ROE

Most businesses need money – from somewhere – to grow 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.

Combination of the debt of the Luye Pharma group and its return on equity of 8.7%

The Luye Pharma group uses a large amount of debt to increase returns. Its debt ratio is 1.23. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Debt increases risk and reduces options for the business in the future, so you generally want to get good returns using it.

summary

Return on equity is useful for comparing the quality of different companies. A business that can earn a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, I would generally prefer the one with the least amount of debt.

But ROE is just one piece of a bigger puzzle, as high quality companies often trade on high income multiples. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. You might want to check out this FREE visualization of analyst forecasts for the business.

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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