In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
K & P International Holdings Limited (HKG:675) generated a below-average return on equity of 1.2% in the past 12 months, while its industry returned 10.7%. 675’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 675’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 675’s returns.
Check out our latest analysis for K & P International Holdings
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.012 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 measured against cost of equity in order to determine the efficiency of K & P International Holdings’s equity capital deployed. Its cost of equity is 9.7%. This means K & P International Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -8.5%. 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 K & P International Holdings 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 artificially increased through excessive borrowing, we should check K & P International Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 17.9%, meaning K & P International Holdings still has headroom to borrow debt to increase profits.