Yuhua Energy Holdings Limited (SEHK:2728) outperformed the Oil and Gas Storage and Transportation industry on the basis of its ROE – producing a higher 16.76% relative to the peer average of 11.06% over the past 12 months. Superficially, this looks great since we know that 2728 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 2728 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 2728’s ROE. See our latest analysis for 2728
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs 2728’s profit against the level of its shareholders’ equity. An ROE of 16.76% implies HK$0.17 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for 2728, which is 10.37%. Given a positive discrepancy of 6.39% between return and cost, this indicates that 2728 pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient 2728 is with its cost management. The other component, asset turnover, illustrates how much revenue 2728 can make from its 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 2728 currently has. Currently the debt-to-equity ratio stands at a reasonable 77.72%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? 2728’s ROE is impressive relative to the industry average and also covers 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%.