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This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Manfield Chemical Holdings Limited (HKG:1561) delivered a less impressive 0.8% ROE over the past year, compared to the 8.8% return generated by its industry. 1561’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 1561’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 1561’s returns.
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Breaking down Return on Equity
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. Manfield Chemical Holdings’s cost of equity is 11.0%. Given a discrepancy of -10.2% between return and cost, this indicated that Manfield Chemical 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Manfield Chemical Holdings’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Manfield Chemical Holdings currently has. Currently, Manfield Chemical Holdings has no debt which means its returns are driven purely by equity capital. This could explain why Manfield Chemical Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.