With an ROE of 12.31%, GCL New Energy Holdings Limited (SEHK:451) outpaced its own industry which delivered a less exciting 8.36% over the past year. While the impressive ratio tells us that 451 has made significant profits from little equity capital, ROE doesn’t tell us if 451 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 451’s ROE is actually sustainable. Check out our latest analysis for GCL New Energy Holdings
What you must know about ROE
Return on Equity (ROE) weighs GCL New Energy Holdings’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$0.12 in earnings from this. 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 GCL New Energy Holdings, which is 11.27%. Since GCL New Energy Holdings’s return covers its cost in excess of 1.04%, its use of equity capital is efficient and likely to be sustainable. Simply put, GCL New Energy Holdings pays less for its capital than what it generates in return. ROE can be broken down into three different 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 reveals how much revenue can be generated from GCL New Energy Holdings’s 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 inflated by excessive debt, we need to examine GCL New Energy Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
What this means for you:
Are you a shareholder? 451’s ROE is impressive relative to the industry average and also covers its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more 451 shares. 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%.