Hong Kong Exchanges and Clearing Limited (SEHK:388) delivered an ROE of 20.12% over the past 12 months, which is an impressive feat relative to its industry average of 8.97% during the same period. While the impressive ratio tells us that 388 has made significant profits from little equity capital, ROE doesn’t tell us if 388 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 388’s ROE is actually sustainable. View our latest analysis for Hong Kong Exchanges and Clearing
What you must know about ROE
Return on Equity (ROE) is a measure of Hong Kong Exchanges and Clearing’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.2 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
ROE is measured against cost of equity in order to determine the efficiency of Hong Kong Exchanges and Clearing’s equity capital deployed. Its cost of equity is 8.38%. This means Hong Kong Exchanges and Clearing returns enough to cover its own cost of equity, with a buffer of 11.75%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 reveals how much revenue can be generated from Hong Kong Exchanges and Clearing’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Hong Kong Exchanges and Clearing’s debt-to-equity level. At 5.21%, Hong Kong Exchanges and Clearing’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? 388’s above-industry ROE is encouraging, and is also in excess of 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%.