International Entertainment Corporation’s (SEHK:1009) most recent return on equity was a substandard 2.72% relative to its industry performance of 10.60% over the past year. Though 1009’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 1009’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 1009’s returns. View our latest analysis for International Entertainment
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs International Entertainment’s profit against the level of its shareholders’ equity. An ROE of 2.72% implies HK$0.03 returned on every HK$1 invested. 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
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 International Entertainment, which is 8.38%. Since International Entertainment’s return does not cover its cost, with a difference of -5.66%, this means its current use of equity is not efficient and not sustainable. Very simply, International Entertainment pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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. Asset turnover reveals how much revenue can be generated from International Entertainment’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check International Entertainment’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 15.57%, which means International Entertainment still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? 1009 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 1009 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%.