With an ROE of 11.13%, Fanhua Inc (NASDAQ:FANH) outpaced its own industry which delivered a less exciting 9.07% over the past year. While the impressive ratio tells us that FANH has made significant profits from little equity capital, ROE doesn’t tell us if FANH has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable FANH’s ROE is. See our latest analysis for FANH
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. An ROE of 11.13% implies $0.11 returned on every $1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. FANH’s cost of equity is 8.49%. Since FANH’s return covers its cost in excess of 2.64%, its use of equity capital is efficient and likely to be sustainable. Simply put, FANH pays less for its capital than what it generates 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue FANH 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 FANH’s historic debt-to-equity ratio. Currently, FANH has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? FANH’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%.