Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). By way of learning-by-doing, we’ll look at ROE to gain a better understanding of Skyfame Realty (Holdings) Limited (HKG:59).
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company’s shareholders.
How Is ROE Calculated?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for Skyfame Realty (Holdings) is:
21% = CN¥1.0b ÷ CN¥4.8b (Based on the trailing twelve months to December 2020).
The ‘return’ is the profit over the last twelve months. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.21 in profit.
Does Skyfame Realty (Holdings) Have A Good Return On Equity?
Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Skyfame Realty (Holdings) has a higher ROE than the average (9.1%) in the Real Estate industry.
That’s what we like to see. With that said, a high ROE doesn’t always indicate high profitability. A higher proportion of debt in a company’s capital structure may also result in a high ROE, where the high debt levels could be a huge risk . Our risks dashboardshould have the 4 risks we have identified for Skyfame Realty (Holdings).
The Importance Of Debt To Return On Equity
Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing 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 required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Combining Skyfame Realty (Holdings)’s Debt And Its 21% Return On Equity
Skyfame Realty (Holdings) clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.81. While its ROE is pretty respectable, the amount of debt the company is carrying currently is not ideal. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
Return on equity is useful for comparing the quality of different businesses. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.
But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. Check the past profit growth by Skyfame Realty (Holdings) by looking at this visualization of past earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.
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