Wharf (Holdings) Limited (SEHK:4) generated a below-average return on equity of 7.24% in the past 12 months, while its industry returned 10.60%. Though 4’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 4’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 4’s returns. Let me show you what I mean by this. View our latest analysis for Wharf (Holdings)
What you must know about ROE
Return on Equity (ROE) is a measure of Wharf (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$0.07 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. Wharf (Holdings)’s cost of equity is 10.11%. This means Wharf (Holdings)’s returns actually do not cover its own cost of equity, with a discrepancy of -2.87%. 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 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Wharf (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 financial leverage can artificially inflate ROE, we need to look at how much debt Wharf (Holdings) currently has. The debt-to-equity ratio currently stands at a low 15.77%, meaning Wharf (Holdings) still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? 4 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 4 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%.