Tianyun International Holdings Limited (SEHK:6836) outperformed the Packaged Foods and Meats industry on the basis of its ROE – producing a higher 21.30% relative to the peer average of 11.75% over the past 12 months. While the impressive ratio tells us that 6836 has made significant profits from little equity capital, ROE doesn’t tell us if 6836 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 6836’s ROE is actually sustainable. Check out our latest analysis for Tianyun International Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Tianyun International Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.21 in earnings from this. 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. Tianyun International Holdings’s cost of equity is 8.38%. Since Tianyun International Holdings’s return covers its cost in excess of 12.92%, its use of equity capital is efficient and likely to be sustainable. Simply put, Tianyun International Holdings pays less 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 Tianyun International Holdings can make from its 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 Tianyun International Holdings currently has. At 15.00%, Tianyun International 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.
What this means for you:
Are you a shareholder? 6836’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 6836 to your portfolio if your personal research is confirming what the ROE is telling you. 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%.