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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Pico Far East Holdings Limited (HKG:752) delivered an ROE of 14.68% over the past 12 months, which is an impressive feat relative to its industry average of 8.16% during the same period. While the impressive ratio tells us that 752 has made significant profits from little equity capital, ROE doesn’t tell us if 752 has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 752’s ROE.
See our latest analysis for Pico Far East Holdings
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Pico Far East Holdings’s cost of equity is 16.76%. Since Pico Far East Holdings’s return does not cover its cost, with a difference of -2.09%, this means its current use of equity is not efficient and not sustainable. Very simply, Pico Far East Holdings pays more for its capital than what it generates in return. ROE can be broken down into three different 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 Pico Far East 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 Pico Far East Holdings’s historic debt-to-equity ratio. At 3.20%, Pico Far East Holdings’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.