Yau Lee Holdings Limited (SEHK:406) delivered a less impressive 0.75% ROE over the past year, compared to the 14.50% return generated by its industry. Though 406’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 406’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 406’s returns. See our latest analysis for 406
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of 406’s profit relative to its shareholders’ equity. An ROE of 0.75% implies HK$0.01 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 measured against cost of equity in order to determine the efficiency of 406’s equity capital deployed. Its cost of equity is 18.12%. Given a discrepancy of -17.37% between return and cost, this indicated that 406 may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue 406 can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable 406’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check 406’s historic debt-to-equity ratio. At 163.86%, 406’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.
What this means for you:
Are you a shareholder? 406’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, its high debt level appears to be a key driver of its ROE and is something you should be mindful of before adding more of 406 to your portfolio. 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%.