With an ROE of 12.30%, Luk Fook Holdings (International) Limited (SEHK:590) outpaced its own industry which delivered a less exciting 8.60% over the past year. On the surface, this looks fantastic since we know that 590 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 590’s ROE is actually sustainable. View our latest analysis for Luk Fook Holdings (International)
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of 590’s profit relative to its shareholders’ equity. An ROE of 12.30% implies HK$0.12 returned on every HK$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. 590’s cost of equity is 8.80%. This means 590 returns enough to cover its own cost of equity, with a buffer of 3.50%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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 shows how much revenue 590 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 590’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check 590’s historic debt-to-equity ratio. Currently, 590 has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? 590’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.