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This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 9.71%, Ten Pao Group Holdings Limited (HKG:1979) outpaced its own industry which delivered a less exciting 9.60% over the past year. While the impressive ratio tells us that 1979 has made significant profits from little equity capital, ROE doesn’t tell us if 1979 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 1979’s ROE is.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Ten Pao Group Holdings’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. 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
Returns are usually compared to costs to measure the efficiency of capital. Ten Pao Group Holdings’s cost of equity is 10.05%. This means Ten Pao Group Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -0.34%. This isn’t sustainable as it implies, very simply, that the company 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Ten Pao Group Holdings can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Ten Pao Group Holdings currently has. Currently the debt-to-equity ratio stands at a reasonable 62.07%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.