New Century Healthcare Holding Co Limited (SEHK:1518) delivered an ROE of 37.70% over the past 12 months, which is an impressive feat relative to its industry average of 10.70% during the same period. Superficially, this looks great since we know that 1518 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 1518 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 1518’s ROE. View our latest analysis for New Century Healthcare Holding
Breaking down Return on Equity
Return on Equity (ROE) weighs New Century Healthcare Holding’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of New Century Healthcare Holding’s equity capital deployed. Its cost of equity is 8.38%. Given a positive discrepancy of 29.33% between return and cost, this indicates that New Century Healthcare Holding pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 New Century Healthcare Holding 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 inflated by excessive debt, we need to examine New Century Healthcare Holding’s debt-to-equity level. Currently, New Century Healthcare Holding has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? 1518 exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 1518 to your portfolio if your personal research is confirming what the ROE is telling you. 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%.