While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. As a learning by doing, we will look at the ROE to better understand YKGI Holdings Berhad (KLSE: YKGI).
ROE or return on equity is a useful tool to assess how effectively a company can generate the returns on investment it has received from its shareholders. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
Check out our latest review for YKGI Holdings Berhad
How to calculate return on equity?
The formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE for YKGI Holdings Berhad is:
5.7% = RM4.5m RM79m (based on the last twelve months up to September 2021).
“Return” refers to a company’s profits over the past year. Another way to look at this is that for every 1 MYR worth of equity, the company was able to earn 0.06 MYR in profit.
Does YKGI Holdings Berhad have a good return on equity?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ a lot within the same industry classification. If you look at the image below, you can see that YKGI Holdings Berhad has a lower than average ROE (10%) in the classification of the metals and mining industry.
Unfortunately, this is not optimal. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing leverage levels are low. A business with high debt levels and low ROE is a combination we like to avoid given the risk involved. You can see the 4 risks we have identified for YKGI Holdings Berhad by visiting our risk dashboard for free on our platform here.
The importance of debt to return on equity
Most businesses need money – from somewhere – 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 and second cases, the ROE will reflect this use of cash for investing in the business. In the latter case, the debt necessary for growth will increase returns, but will have no impact on equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
Combine YKGI Holdings Berhad Debt and 5.7% Return on Equity
YKGI Holdings Berhad clearly uses a high amount of debt to boost returns, as it has a debt-to-equity ratio of 1.00. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Leverage increases risk and reduces options for the business in the future, so you usually want to get good returns using it.
Conclusion
Return on equity is useful for comparing the quality of different companies. A business that can earn a high return on equity without going into debt can be considered a high quality business. If two companies have the same ROE, I would generally prefer the one with the least amount of debt.
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. So I think it’s worth checking this out free this detailed graphic past earnings, income and cash flow.
Sure, you might find a fantastic investment looking elsewhere. So take a look at this free list of interesting companies.
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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 documents. Simply Wall St has no position in any of the stocks mentioned.