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Can Zhong Ao Home Group Limited (HKG:1538) Maintain Its Strong Returns?

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). We'll use ROE to examine Zhong Ao Home Group Limited (HKG:1538), by way of a worked example.

Over the last twelve months Zhong Ao Home Group has recorded a ROE of 17%. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.17.

Check out our latest analysis for Zhong Ao Home Group

How Do You Calculate ROE?

The formula for ROE is:

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

Or for Zhong Ao Home Group:

17% = CN¥113m ÷ CN¥680m (Based on the trailing twelve months to June 2019.)

It's easy to understand the 'net profit' part of that equation, but 'shareholders' equity' requires further explanation. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Mean?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.

Does Zhong Ao Home Group 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Zhong Ao Home Group has a superior ROE than the average (8.4%) company in the Real Estate industry.

SEHK:1538 Past Revenue and Net Income, February 19th 2020
SEHK:1538 Past Revenue and Net Income, February 19th 2020

That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.

Why You Should Consider Debt When Looking At ROE

Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Zhong Ao Home Group's Debt And Its 17% ROE

While Zhong Ao Home Group does have some debt, with debt to equity of just 0.25, we wouldn't say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.

The Key Takeaway

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.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. You can see how the company has grow in the past by looking at this FREE detailed graph of past earnings, revenue and cash flow.

Of course Zhong Ao Home Group 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.