AAC Technologies Holdings Inc (SEHK:2018) outperformed the Electronic Manufacturing Services industry on the basis of its ROE – producing a higher 35.91% relative to the peer average of 12.06% over the past 12 months. On the surface, this looks fantastic since we know that 2018 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 2018’s ROE is actually sustainable. See our latest analysis for AAC Technologies Holdings
Breaking down Return on Equity
Return on Equity (ROE) weighs AAC Technologies Holdings’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.36 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. AAC Technologies Holdings’s cost of equity is 9.51%. Since AAC Technologies Holdings’s return covers its cost in excess of 26.40%, its use of equity capital is efficient and likely to be sustainable. Simply put, AAC Technologies Holdings pays less for its capital than what it generates in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue AAC Technologies Holdings can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check AAC Technologies Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 31.82%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? 2018 exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.