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.
E Bon Holdings Limited (HKG:599) outperformed the Trading Companies and Distributors industry on the basis of its ROE – producing a higher 9.22% relative to the peer average of 8.97% over the past 12 months. Superficially, this looks great since we know that 599 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 599 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 599’s ROE.
View our latest analysis for E. Bon Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of 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
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 E. Bon Holdings, which is 10.13%. Given a discrepancy of -0.91% between return and cost, this indicated that E. Bon Holdings may be paying more for its capital than what it’s generating 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 E. Bon Holdings can make from its 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 ROE can be artificially increased through excessive borrowing, we should check E. Bon Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 8.64%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.