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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 Telecom Service One Holdings Limited (HKG:3997), by way of a worked example.

Over the last twelve months Telecom Service One Holdings has recorded a ROE of 9.3%. That means that for every HK$1 worth of shareholders' equity, it generated HK$0.093 in profit.

Check out our latest analysis for Telecom Service One Holdings

How Do I Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Telecom Service One Holdings:

9.3% = HK$9.4m ÷ HK$101m (Based on the trailing twelve months to March 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. 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 Return On Equity Signify?

ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. 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 Telecom Service One Holdings Have A Good ROE?

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. If you look at the image below, you can see Telecom Service One Holdings has a similar ROE to the average in the Commercial Services industry classification (10%).

That's neither particularly good, nor bad. 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 like to buy stocks alongside management, then you might just love this free list of companies. (Hint: insiders have been buying them).

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing 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, 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.

Telecom Service One Holdings's Debt And Its 9.3% ROE

One positive for shareholders is that Telecom Service One Holdings does not have any net debt! Even though I don't think its ROE is that great, I think it's very respectable when you consider it has no debt. At the end of the day, when a company has zero debt, it is in a better position to take future growth 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 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. 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 Telecom Service One Holdings by looking at this visualization of past earnings, revenue and cash flow.

Of course Telecom Service One Holdings 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.

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.

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. Thank you for reading.