China Baofeng (International) Limited (SEHK:3966) outperformed the Home Furnishings industry on the basis of its ROE – producing a higher 84.22% relative to the peer average of 13.73% over the past 12 months. On the surface, this looks fantastic since we know that 3966 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 3966’s ROE. See our latest analysis for China Baofeng (International)
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of China Baofeng (International)’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. China Baofeng (International)’s cost of equity is 10.26%. Since China Baofeng (International)’s return covers its cost in excess of 73.97%, its use of equity capital is efficient and likely to be sustainable. Simply put, China Baofeng (International) 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue China Baofeng (International) can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Baofeng (International) currently has. Currently the debt-to-equity ratio stands at a low 39.66%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? 3966 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%.