This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
E-Commodities Holdings Limited (HKG:1733) delivered an ROE of 31.4% over the past 12 months, which is an impressive feat relative to its industry average of 10.7% during the same period. Superficially, this looks great since we know that 1733 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 1733 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 1733’s ROE is actually sustainable.
View our latest analysis for E-Commodities Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of E-Commodities Holdings’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 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-Commodities Holdings, which is 15.9%. Since E-Commodities Holdings’s return covers its cost in excess of 15.5%, its use of equity capital is efficient and likely to be sustainable. Simply put, E-Commodities Holdings pays less 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 E-Commodities 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 artificially increased through excessive borrowing, we should check E-Commodities Holdings’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 133%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.