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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Summit Ascent Holdings Limited’s (HKG:102) most recent return on equity was a substandard 0.8% relative to its industry performance of 7.0% over the past year. 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 102’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 102’s returns. Let me show you what I mean by this.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Summit Ascent Holdings’s profit relative to its shareholders’ equity. An ROE of 0.8% implies HK$0.0082 returned on every HK$1 invested. 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. Summit Ascent Holdings’s cost of equity is 14.9%. Since Summit Ascent Holdings’s return does not cover its cost, with a difference of -14.1%, this means its current use of equity is not efficient and not sustainable. Very simply, Summit Ascent Holdings pays more for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Summit Ascent Holdings can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Summit Ascent Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 15.4%, which means Summit Ascent Holdings still has headroom to take on more leverage in order to increase profits.