1957 & Co (Hospitality) Limited (SEHK:8495) generated a below-average return on equity of 1.54% in the past 12 months, while its industry returned 1.65%. Though 8495’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 8495’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 8495’s returns. Let me show you what I mean by this. View our latest analysis for 1957 (Hospitality)
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs 1957 (Hospitality)’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.02 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 1957 (Hospitality)’s equity capital deployed. Its cost of equity is 18.12%. This means 1957 (Hospitality)’s returns actually do not cover its own cost of equity, with a discrepancy of -16.58%. 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 dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue 1957 (Hospitality) 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 artificially increased through excessive borrowing, we should check 1957 (Hospitality)’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its below-average ROE is already being driven by significant debt levels.
What this means for you:
Are you a shareholder? 8495’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more 8495 shares. 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%.