Lingbao Gold Group Company Ltd (SEHK:3330) delivered a less impressive 2.64% ROE over the past year, compared to the 8.54% return generated by its industry. 3330’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 3330’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 3330’s returns. View our latest analysis for Lingbao Gold Group Company
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Lingbao Gold Group Company’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
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 Lingbao Gold Group Company, which is 18.12%. Since Lingbao Gold Group Company’s return does not cover its cost, with a difference of -15.48%, this means its current use of equity is not efficient and not sustainable. Very simply, Lingbao Gold Group Company 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
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 Lingbao Gold Group Company 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 inflated by excessive debt, we need to examine Lingbao Gold Group Company’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its below-average ROE is already being driven by significant debt levels.