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Vodatel Networks Holdings Limited (SEHK:8033) delivered a less impressive 6.30% ROE over the past year, compared to the 9.43% return generated by its industry. 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 8033’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 8033’s returns. View our latest analysis for Vodatel Networks Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Vodatel Networks Holdings’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.06 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of Vodatel Networks Holdings’s equity capital deployed. Its cost of equity is 10.72%. Since Vodatel Networks Holdings’s return does not cover its cost, with a difference of -4.42%, this means its current use of equity is not efficient and not sustainable. Very simply, Vodatel Networks Holdings 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
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 Vodatel Networks Holdings’s 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 Vodatel Networks Holdings’s debt-to-equity level. Currently Vodatel Networks Holdings has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Vodatel Networks Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.