Country Garden Holdings Company Limited (SEHK:2007) delivered an ROE of 16.95% over the past 12 months, which is an impressive feat relative to its industry average of 10.60% during the same period. On the surface, this looks fantastic since we know that 2007 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 2007’s ROE is. Check out our latest analysis for Country Garden Holdings
What you must know about ROE
Return on Equity (ROE) is a measure of Country Garden Holdings’s profit relative to its shareholders’ equity. An ROE of 16.95% implies HK$0.17 returned on every HK$1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Country Garden Holdings’s cost of equity is 9.45%. Since Country Garden Holdings’s return covers its cost in excess of 7.50%, its use of equity capital is efficient and likely to be sustainable. Simply put, Country Garden Holdings 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
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 Country Garden 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 ROE can be inflated by excessive debt, we need to examine Country Garden Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 172.24%, meaning the above-average ratio is a result of a large amount of debt.
What this means for you:
Are you a shareholder? 2007 exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more 2007 shares. 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%.