I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Lifestyle China Group Limited (HKG:2136) generated a below-average return on equity of 4.65% in the past 12 months, while its industry returned 7.69%. 2136’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 2136’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 2136’s returns. Let me show you what I mean by this.
See our latest analysis for Lifestyle China Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Lifestyle China Group’s profit relative to its shareholders’ equity. An ROE of 4.65% implies HK$0.046 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Lifestyle China Group, which is 8.44%. Since Lifestyle China Group’s return does not cover its cost, with a difference of -3.79%, this means its current use of equity is not efficient and not sustainable. Very simply, Lifestyle China Group pays more for its capital than what it generates 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. The other component, asset turnover, illustrates how much revenue Lifestyle China Group can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Lifestyle China Group’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 17.03%, meaning Lifestyle China Group still has headroom to borrow debt to increase profits.