In This Article:
I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Chen Hsong Holdings Limited (HKG:57) delivered a less impressive 3.57% ROE over the past year, compared to the 7.15% return generated by its industry. 57’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 57’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 57’s returns. Let me show you what I mean by this.
See our latest analysis for Chen Hsong Holdings
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of 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. Chen Hsong Holdings’s cost of equity is 10.51%. This means Chen Hsong Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -6.95%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be broken down into three different 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 Chen Hsong Holdings can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Chen Hsong Holdings currently has. Currently Chen Hsong Holdings has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Chen Hsong Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.