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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Kerry Properties Limited (HKG:683) delivered an ROE of 10.2% over the past 12 months, which is an impressive feat relative to its industry average of 9.2% during the same period. Superficially, this looks great since we know that 683 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 683 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 683’s ROE is.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Kerry Properties’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Kerry Properties’s equity capital deployed. Its cost of equity is 11.3%. Since Kerry Properties’s return does not cover its cost, with a difference of -1.1%, this means its current use of equity is not efficient and not sustainable. Very simply, Kerry Properties 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
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 Kerry Properties’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Kerry Properties currently has. The debt-to-equity ratio currently stands at a low 29.2%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Kerry Properties’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.