Hengdeli Holdings Limited (SEHK:3389) generated a below-average return on equity of 2.95% in the past 12 months, while its industry returned 8.60%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 3389’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 3389’s returns. Let me show you what I mean by this. Check out our latest analysis for Hengdeli Holdings
Breaking down Return on Equity
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. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Hengdeli Holdings, which is 13.17%. Since Hengdeli Holdings’s return does not cover its cost, with a difference of -10.22%, this means its current use of equity is not efficient and not sustainable. Very simply, Hengdeli Holdings 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. The other component, asset turnover, illustrates how much revenue Hengdeli Holdings 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 Hengdeli Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 19.98%, meaning Hengdeli Holdings still has headroom to borrow debt to increase profits.