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). To keep the lesson grounded in practicality, we'll use ROE to better understand New China Life Insurance Company Ltd. (SHSE:601336).

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

How Do You Calculate Return On Equity?

Return on equity 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 New China Life Insurance is:

22% = CN¥20b ÷ CN¥91b (Based on the trailing twelve months to September 2024).

The 'return' is the profit over the last twelve months. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.22 in profit.

Does New China Life Insurance 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, New China Life Insurance has a higher ROE than the average (11%) in the Insurance industry.

That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. To know the 3 risks we have identified for New China Life Insurance visit our risks dashboard for free.

The Importance Of Debt To Return On Equity

Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining New China Life Insurance's Debt And Its 22% Return On Equity

New China Life Insurance clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 2.46. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

Conclusion

Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course New China Life Insurance may not be the best stock to buy. So you may wish to see this free collection of other companies that have 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.