One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. We’ll use ROE to take a look at Oriental Culture Holding LTD (NASDAQ: OCG), using a real-world example.
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 Oriental Culture Holding
How is the ROE calculated?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE for Oriental Culture Holding is:
27% = US $ 12 million ÷ US $ 44 million (based on the last twelve months to June 2021).
The “return” is the annual profit. This means that for every dollar in shareholders’ equity, the company generated $ 0.27 in profit.
Does Oriental Culture Holding have a good ROE?
An easy way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. Fortunately, Oriental Culture Holding has an above-average ROE (21%) for the online retail industry.
This is what we love to see. However, keep in mind that a high ROE does not necessarily indicate efficient profit generation. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk.
What is the impact of debt on ROE?
Most businesses need money – from somewhere – to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. 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 the debt of Oriental Culture Holding and its return on equity of 27%
Oriental Culture Holding has no net debt, which is positive for shareholders. Its high ROE already indicates a high quality business, but the lack of debt is icing on the cake. After all, when a business has a strong balance sheet, it can often find ways to invest in growth, even if it takes a while.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
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. You can see how the business has grown in the past by checking out this FREE detailed graphic past earnings, income and cash flow.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
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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 any stock 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.