Far East Holdings International Limited (SEHK:36) generated a below-average return on equity of 1.02% in the past 12 months, while its industry returned 4.43%. 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 36’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 36’s returns. Check out our latest analysis for Far East Holdings International
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Far East Holdings International’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$0.01 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
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 Far East Holdings International, which is 9.72%. Given a discrepancy of -8.70% between return and cost, this indicated that Far East Holdings International may be paying more for its capital than what it’s generating 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
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 Far East Holdings International 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 inflated by excessive debt, we need to examine Far East Holdings International’s debt-to-equity level. Currently, Far East Holdings International has no debt which means its returns are driven purely by equity capital. This could explain why Far East Holdings International’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.