AP Rentals Holdings Limited (SEHK:1496) delivered a less impressive 8.14% ROE over the past year, compared to the 8.95% return generated by its industry. 1496’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 1496’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 1496’s returns. Let me show you what I mean by this. View our latest analysis for AP Rentals Holdings
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 8.14% implies HK$0.08 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
ROE is measured against cost of equity in order to determine the efficiency of 1496’s equity capital deployed. Its cost of equity is 9.05%. Given a discrepancy of -0.92% between return and cost, this indicated that 1496 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. The other component, asset turnover, illustrates how much revenue 1496 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 1496’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt 1496 currently has. At 11.09%, 1496’s debt-to-equity ratio appears low and indicates that 1496 still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? 1496’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 1496 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%.