GCL-Poly Energy Holdings Limited (SEHK:3800) delivered an ROE of 9.10% over the past 12 months, which is an impressive feat relative to its industry average of 8.36% during the same period. On the surface, this looks fantastic since we know that 3800 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 3800’s ROE. See our latest analysis for GCL-Poly Energy Holdings
Breaking down Return on Equity
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. 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 measured against cost of equity in order to determine the efficiency of GCL-Poly Energy Holdings’s equity capital deployed. Its cost of equity is 18.12%. Since GCL-Poly Energy Holdings’s return does not cover its cost, with a difference of -9.02%, this means its current use of equity is not efficient and not sustainable. Very simply, GCL-Poly Energy Holdings pays more 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue GCL-Poly Energy Holdings can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine GCL-Poly Energy Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 191.46%, meaning the above-average ratio is a result of a large amount of debt.
What this means for you:
Are you a shareholder? 3800 exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Additionally, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of 3800 to your portfolio. 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%.