While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine Li Ning Company Limited (HKG:2331), by way of a worked example.

Our data shows Li Ning has a return on equity of 21% for the last year. Another way to think of that is that for every HK$1 worth of equity in the company, it was able to earn HK$0.21.

View our latest analysis for Li Ning

How Do I Calculate Return On Equity?

The formula for ROE is:

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

Or for Li Ning:

21% = CN¥1.5b ÷ CN¥7.1b (Based on the trailing twelve months to December 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. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does Return On Equity Mean?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.

Does Li Ning 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. As is clear from the image below, Li Ning has a better ROE than the average (8.8%) in the Luxury industry.

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.

How Does Debt Impact 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 two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.

Combining Li Ning's Debt And Its 21% Return On Equity

Shareholders will be pleased to learn that Li Ning has not one iota of net debt! Its solid ROE indicates a good business, especially when you consider it is not using leverage. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.

The Bottom Line On ROE

Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. 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. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So I think it may be worth checking this free report on analyst forecasts for the company.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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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