Milestone Builder Holdings Limited (SEHK:1667) delivered a less impressive 8.89% ROE over the past year, compared to the 14.90% return generated by its industry. Though 1667’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 1667’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 1667’s returns. Let me show you what I mean by this. Check out our latest analysis for Milestone Builder Holdings
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Milestone Builder Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.09 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Milestone Builder Holdings’s cost of equity is 8.38%. While Milestone Builder Holdings’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Milestone Builder Holdings which is encouraging. ROE can be split up into three useful 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 Milestone Builder 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 Milestone Builder Holdings’s debt-to-equity level. At 35.94%, Milestone Builder Holdings’s debt-to-equity ratio appears low and indicates that Milestone Builder Holdings still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? Even though 1667 returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 1667 to your portfolio if your personal research is confirming what the ROE is telling you. 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%.