In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Chanhigh Holdings Limited (HKG:2017) generated a below-average return on equity of 4.3% in the past 12 months, while its industry returned 11.4%. Though 2017’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 2017’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 2017’s returns. Let me show you what I mean by this.
Check out our latest analysis for Chanhigh Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Chanhigh Holdings’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. 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. Chanhigh Holdings’s cost of equity is 8.4%. Given a discrepancy of -4.2% between return and cost, this indicated that Chanhigh Holdings may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Chanhigh Holdings’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 financial leverage can artificially inflate ROE, we need to look at how much debt Chanhigh Holdings currently has. Currently the debt-to-equity ratio stands at a low 15.6%, which means Chanhigh Holdings still has headroom to take on more leverage in order to increase profits.