Should you be excited about the 33% return on equity of Cheshi Holdings Limited (HKG: 1490)?
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 matters. As a learning-by-doing, we’ll take a look at the ROE to better understand Cheshi Holdings Limited (HKG: 1490).
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it reveals the company’s success in turning shareholders’ investments into profits.
Check out our latest analysis for Cheshi Holdings
How do you calculate return on equity?
the ROE formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of Cheshi Holdings is:
33% = 65m CN ¥ ÷ 198m CN ¥ (based on the last twelve months up to December 2020).
The “return” is the income the business has earned over the past year. So this means that for every Hong Kong dollar invested by its shareholder, the company generates a profit of 0.33 Hong Kong dollar.
Does Cheshi Holdings have a good return on equity?
By comparing a company’s ROE to its industry average, we can get a quick measure of its quality. However, this method is only useful as a rough check, as companies differ a little within the same industry classification. Fortunately, Cheshi Holdings has an above-average ROE (6.2%) for the media industry.
This is clearly positive. 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 can represent a huge risk. You can see the 3 risks we have identified for Cheshi Holdings by visiting our risk dashboard for free on our platform here.
The importance of debt to return on equity
Companies generally have to invest money to increase their profits. This liquidity can come from issuance of shares, retained earnings or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, using debt will improve returns, but not change 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 Cheshi Holdings debt and 33% return on equity
Cheshi Holdings has a debt to equity ratio of 0.24, which is far from excessive. Its ROE is very impressive and, given its modest debt, this suggests that the company is of high quality. Careful use of debt to increase returns is often very good for shareholders. However, this could reduce the company’s ability to take advantage of future opportunities.
Return on equity is one way we can compare the quality of business of different companies. A business that can earn a high return on equity without debt could be considered a high quality business. All other things being equal, a higher ROE is preferable.
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. Check out Cheshi Holdings’ past earnings growth by looking at this visualization of past earnings, income, and cash flow.
But note: Cheshi Holdings may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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