China Shun Ke Long Holdings Limited (SEHK:974) delivered an ROE of 8.23% over the past 12 months, which is an impressive feat relative to its industry average of 7.59% during the same period. Superficially, this looks great since we know that 974 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 974 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 974’s ROE is actually sustainable. Check out our latest analysis for China Shun Ke Long Holdings
What you must know about ROE
Return on Equity (ROE) weighs China Shun Ke Long Holdings’s profit against the level of its shareholders’ equity. An ROE of 8.23% implies HK$0.08 returned on every HK$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of China Shun Ke Long Holdings’s equity capital deployed. Its cost of equity is 8.38%. This means China Shun Ke Long Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -0.15%. 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
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 China Shun Ke Long Holdings can make from its 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 artificially increased through excessive borrowing, we should check China Shun Ke Long Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 34.80%, 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? 974 exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 974 still has room to improve shareholder returns by raising debt to fund new investments. 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%.