Min Xin Holdings Limited (SEHK:222) generated a below-average return on equity of 4.91% in the past 12 months, while its industry returned 6.36%. 222’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 222’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 222’s returns. Check out our latest analysis for Min Xin Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of 222’s profit relative to its shareholders’ equity. For example, if 222 invests HK$1 in the form of equity, it will generate HK$0.05 in earnings from this. 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 222, which is 8.38%. Since 222’s return does not cover its cost, with a difference of -3.46%, this means its current use of equity is not efficient and not sustainable. Very simply, 222 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
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 222’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable 222’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt 222 currently has. At 11.79%, 222’s debt-to-equity ratio appears low and indicates that 222 still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? 222 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 222 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.