Should we be delighted with the 25% ROE of Smart-Core Holdings Limited (HKG: 2166)?
One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. We’ll use the ROE to take a look at Smart-Core Holdings Limited (HKG: 2166), using a real-world example.
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
See our latest analysis for Smart-Core Holdings
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE of Smart-Core Holdings is:
25% = HK $ 212 million ÷ HK $ 836 million (based on the last twelve months to June 2021).
The “return” is the amount earned after tax over the past twelve months. This means that for every HK $ 1 worth of equity, the company generated HK $ 0.25 in profit.
Does Smart-Core Holdings have a good return on equity?
By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As you can see in the graph below, Smart-Core Holdings has an above-average ROE (9.2%) for the electronics industry.
This is what we love to see. That said, high ROE doesn’t always indicate high profitability. Besides changes in net income, high ROE can also be the result of high leverage to equity, which indicates risk. You can see the 3 risks we have identified for Smart-Core Holdings by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Almost all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the profits of the previous year (retained earnings), from the issuance of new shares or from loans. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve returns, but will not affect equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Smart-Core Holdings’ debt and its 25% ROE
Smart-Core Holdings uses a large amount of debt to increase returns. It has a debt ratio of 1.62. There is no doubt that the ROE is impressive, but it should be borne in mind that the measurement could have been lower had the company reduced its debt. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using it.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. Check out the past earnings growth of Smart-Core Holdings by examining this visualization of past earnings, revenue, and cash flow.
But beware : Smart-Core 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.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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