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 CK Life Sciences Int'l., (Holdings) Inc. (HKG:775), by way of a worked example.

ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for CK Life Sciences Int'l. (Holdings)

How Is ROE Calculated?

ROE can be calculated by using the formula:

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

So, based on the above formula, the ROE for CK Life Sciences Int'l. (Holdings) is:

3.6% = HK$163m ÷ HK$4.5b (Based on the trailing twelve months to December 2021).

The 'return' is the yearly profit. One way to conceptualize this is that for each HK$1 of shareholders' capital it has, the company made HK$0.04 in profit.

Does CK Life Sciences Int'l. (Holdings) Have A Good ROE?

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 shown in the graphic below, CK Life Sciences Int'l. (Holdings) has a lower ROE than the average (8.1%) in the Biotechs industry classification.

Unfortunately, that's sub-optimal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. You can see the 3 risks we have identified for CK Life Sciences Int'l. (Holdings) by visiting our risks dashboard for free on our platform here.

Why You Should Consider Debt When Looking At ROE

Virtually all companies need money to invest in the business, to grow 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

CK Life Sciences Int'l. (Holdings)'s Debt And Its 3.6% ROE

CK Life Sciences Int'l. (Holdings) does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.25. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

Conclusion

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. 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. Check the past profit growth by CK Life Sciences Int'l. (Holdings) by looking at this visualization of past earnings, revenue and cash flow.

But note: CK Life Sciences Int'l. (Holdings) may not be the best stock to buy. So take a peek at this free list of interesting companies with high ROE and low debt.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.