Wheelock and Company Limited (SEHK:20) delivered a less impressive 7.49% ROE over the past year, compared to the 10.60% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 20’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 20’s returns. Let me show you what I mean by this. View our latest analysis for Wheelock
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 7.49% implies HK$0.07 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 measured against cost of equity in order to determine the efficiency of Wheelock’s equity capital deployed. Its cost of equity is 10.68%. Since Wheelock’s return does not cover its cost, with a difference of -3.19%, this means its current use of equity is not efficient and not sustainable. Very simply, Wheelock 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. Asset turnover shows how much revenue Wheelock can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Wheelock’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 23.66%, meaning Wheelock still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? 20’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 20 still has room to improve shareholder returns by raising debt to fund new investments. 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%.