In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
PAX Global Technology Limited’s (HKG:327) most recent return on equity was a substandard 8.1% relative to its industry performance of 10.4% over the past year. 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 327’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 327’s returns. Let me show you what I mean by this.
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What you must know about ROE
Return on Equity (ROE) is a measure of PAX Global Technology’s profit relative to its shareholders’ equity. An ROE of 8.1% implies HK$0.081 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. PAX Global Technology’s cost of equity is 8.4%. This means PAX Global Technology’s returns actually do not cover its own cost of equity, with a discrepancy of -0.3%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue PAX Global Technology can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check PAX Global Technology’s historic debt-to-equity ratio. Currently PAX Global Technology has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why PAX Global Technology’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.