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). By way of learning-by-doing, we’ll look at ROE to gain a better understanding of UUE Holdings Berhad (KLSE:UUE).
Return on equity or ROE is a key measure used to assess how efficiently a company’s management is utilizing the company’s capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity
So, based on the above formula, the ROE for UUE Holdings Berhad is:
25% = RM16m ÷ RM63m (Based on the trailing twelve months to February 2024).
The ‘return’ refers to a company’s earnings over the last year. One way to conceptualize this is that for each MYR1 of shareholders’ capital it has, the company made MYR0.25 in profit.
One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As is clear from the image below, UUE Holdings Berhad has a better ROE than the average (8.1%) in the Construction industry.
That is a good sign. With that said, a high ROE doesn’t always indicate high profitability. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. To know the 2 risks we have identified for UUE Holdings Berhad visit our risks dashboard for free.
Most companies need money — from somewhere — to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders’ equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
Although UUE Holdings Berhad does use debt, its debt to equity ratio of 0.36 is still low. The combination of modest debt and a very impressive ROE does suggest that the business is high quality. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.
Return on equity is useful for comparing the quality of different businesses. In our books, the highest quality companies have high return on equity, despite low debt. 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.
But when a business is high quality, the market often bids it up to a price that reflects this. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.
Of course UUE Holdings Berhad 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.