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Does Charmacy Pharmaceutical Co., Ltd. (HKG:2289) Create Value For Shareholders?

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 Charmacy Pharmaceutical Co., Ltd. (HKG:2289).

Charmacy Pharmaceutical has a ROE of 8.3%, based on the last twelve months. One way to conceptualize this, is that for each HK$1 of shareholders' equity it has, the company made HK$0.08 in profit.

View our latest analysis for Charmacy Pharmaceutical

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for Charmacy Pharmaceutical:

8.3% = CN¥40m ÷ CN¥484m (Based on the trailing twelve months to December 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does ROE Mean?

Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.

Does Charmacy Pharmaceutical Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. The image below shows that Charmacy Pharmaceutical has an ROE that is roughly in line with the Healthcare industry average (8.6%).

SEHK:2289 Past Revenue and Net Income April 2nd 2020
SEHK:2289 Past Revenue and Net Income April 2nd 2020

That isn't amazing, but it is respectable. ROE tells us about the quality of the business, but it does not give us much of an idea if the share price is cheap. If you are like me, then you will not want to miss this free list of growing companies that insiders are buying.

How Does Debt Impact ROE?

Virtually all companies need money to invest in the business, to grow 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 used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Charmacy Pharmaceutical's Debt And Its 8.3% ROE

Charmacy Pharmaceutical clearly uses a significant amount of debt to boost returns, as it has a debt to equity ratio of 1.30. The company doesn't have a bad ROE, but it is less than ideal tht it has had to use debt to achieve its returns. 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.

The Key Takeaway

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. 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. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow.

Of course Charmacy Pharmaceutical 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

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