Keck Seng Investments (Hong Kong) Limited (SEHK:184) outperformed the Hotels, Resorts and Cruise Lines industry on the basis of its ROE – producing a higher 6.26% relative to the peer average of 1.65% over the past 12 months. Superficially, this looks great since we know that 184 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 184 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 184’s ROE is actually sustainable. View our latest analysis for Keckng Investments (Hong Kong)
What you must know about ROE
Return on Equity (ROE) weighs 184’s profit against the level of its shareholders’ equity. An ROE of 6.26% implies HK$0.06 returned on every HK$1 invested. 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. 184’s cost of equity is 18.12%. Given a discrepancy of -11.86% between return and cost, this indicated that 184 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from 184’s 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 184’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine 184’s debt-to-equity level. At 42.64%, 184’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? 184 exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 184 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.