Hengxin Technology Ltd (SGX:I85) generated a below-average return on equity of 8.48% in the past 12 months, while its industry returned 12.06%. Though I85’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 I85’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of I85’s returns. View our latest analysis for Hengxin Technology
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Hengxin Technology’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.08 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 measured against cost of equity in order to determine the efficiency of Hengxin Technology’s equity capital deployed. Its cost of equity is 10.30%. This means Hengxin Technology’s returns actually do not cover its own cost of equity, with a discrepancy of -1.82%. This isn’t sustainable as it implies, very simply, that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Hengxin Technology can generate with its current 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 Hengxin Technology’s debt-to-equity level. Currently, Hengxin Technology has no debt which means its returns are driven purely by equity capital. This could explain why Hengxin Technology’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? I85 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means I85 still has room to improve shareholder returns by raising debt to fund new investments. 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%.