I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Xinghua Port Holdings Ltd (HKG:1990) delivered a less impressive 7.7% ROE over the past year, compared to the 10.3% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 1990’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 1990’s returns. Let me show you what I mean by this.
Check out our latest analysis for Xinghua Port Holdings
What you must know about ROE
Return on Equity (ROE) is a measure of Xinghua Port Holdings’s profit relative to its shareholders’ equity. An ROE of 7.7% implies HK$0.077 returned on every HK$1 invested. 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 Xinghua Port Holdings’s equity capital deployed. Its cost of equity is 10.6%. Given a discrepancy of -3.0% between return and cost, this indicated that Xinghua Port Holdings may be paying more for its capital than what it’s generating 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. The other component, asset turnover, illustrates how much revenue Xinghua Port Holdings can make from its 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 artificially increased through excessive borrowing, we should check Xinghua Port Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 70.3%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.