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. To keep the lesson practical, we’ll use ROE to better understand RLX Technology Inc. (NYSE: RLX).
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 short, the ROE shows the profit that each dollar generates compared to the investments of its shareholders.
Check out our latest review for RLX technology
How do you calculate return on equity?
ROE can be calculated using the formula:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE of RLX technology is:
9.8% = CN ¥ 1.3b ÷ CN ¥ 13b (based on the last twelve months up to September 2021).
The “return” is the profit of the last twelve months. This therefore means that for every $ 1 invested by its shareholder, the company generates a profit of $ 0.10.
Does RLX technology have a good return on equity?
An easy way to determine if a company has a good return on equity is to compare it to the average in its industry. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As shown in the image below, RLX Technology has a lower ROE than the tobacco industry average (17%).
It is certainly not ideal. 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 highly leveraged business with a low ROE is a whole different story and a risky investment on our books.
The importance of debt to return on equity
Almost all businesses need money to invest in the business, to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (equity) or debt. In the case of the first and second options, the ROE will reflect this use of cash, for growth. 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 RLX Technology’s debt and its 9.8% return on equity
A positive point for shareholders is that RLX Technology has no net debt! Even though I don’t think his ROE is that high, I think he is very respectable considering that he has no debt. Ultimately, when a business is debt free, it is in a better position to seize future growth opportunities.
Return on equity is a way to compare the business quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, I would generally prefer the one with the least amount of debt.
But when a company is of high quality, the market often offers it up to a price that reflects that. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be taken into account. You might want to take a look at this data-rich interactive chart of the forecast for the business.
But beware : RLX technology might not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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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.