Future Data Group Limited’s (SEHK:8229) most recent return on equity was a substandard 11.03% relative to its industry performance of 14.80% over the past year. Though 8229’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 8229’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 8229’s returns. Check out our latest analysis for Future Data Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Future Data Group’s profit against the level of its shareholders’ equity. An ROE of 11.03% implies HK$0.11 returned on every HK$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Future Data Group’s cost of equity is 9.83%. Some of Future Data Group’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Future Data Group which is reassuring. 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 shows how much revenue Future Data Group 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 Future Data Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 17.32%, which means Future Data Group still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? While 8229 exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.