Boasting a return on equity of 43%, is Ko Yo Chemical (Group) Limited (HKG:827) a superior stock?

While some investors are already familiar with financial metrics (hat trick), this article is for those who want to learn more about return on equity (ROE) and why it matters. Through learning-by-doing, we will examine ROE to better understand Ko Yo Chemical (Group) Limited (HKG:827).

Return on equity or ROE is an important factor for a shareholder to consider as it tells them how much of their capital is being reinvested. In simpler terms, it measures a company’s profitability relative to equity.

Our analysis indicates that 827 is potentially undervalued!

How to calculate return on equity?

The return on equity formula is:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the formula above, the ROE for Ko Yo Chemical (Group) is:

43% = CN¥452 million ÷ CN¥1.1 billion (based on the last twelve months to June 2022).

The “return” is the annual profit. One way to conceptualize this is that for every HK$1 of share capital it has, the company has made a profit of HK$0.43.

Does Ko Yo Chemical (Group) have a good return on equity?

A 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, as companies differ quite a bit within the same industry classification. As you can see in the graph below, Ko Yo Chemical (Group) has an ROE above the average (12%) for the chemical industry.

SEHK: 827 Return on Equity October 11, 2022

It’s a good sign. Keep in mind that a high ROE does not always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in a high ROE, where high debt levels could be a huge risk. Our risk dashboard should contain the 2 risks we have identified for Ko Yo Chemical (Group).

What is the impact of debt on return on equity?

Companies generally need to invest money to increase their profits. This money can come from issuing shares, retained earnings or debt. In the first and second case, the ROE will reflect this use of cash for investment in the business. In the latter case, debt used for growth will enhance returns, but will not affect total equity. This will make the ROE better than if no debt was used.

Combine Ko Yo Chemical (group) debt and its return on equity of 43%

Ko Yo Chemical (Group) is clearly using a high amount of debt to boost its returns, as its debt to equity ratio is 2.37. Its ROE is quite impressive, but it probably would have been lower without the use of debt. Investors need to think carefully about how a company would perform if it weren’t able to borrow so easily, as credit markets change over time.

Conclusion

Return on equity is useful for comparing the quality of different companies. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, I would generally prefer the one with less debt.

But when a company is of high quality, the market often gives it 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 considered. So I think it’s worth checking it out free this detailed graph past profits, revenue and cash flow.

If you’d rather check out another company – one with potentially superior finances – then don’t miss this free list of attractive companies, which have a high return on equity and low debt.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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