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PAX Global Technology Limited’s (SEHK:327) most recent return on equity was a substandard 8.64% relative to its industry performance of 10.94% over the past year. 327’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 327’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 327’s returns. Let me show you what I mean by this. View our latest analysis for PAX Global Technology
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of PAX Global Technology’s profit relative to its shareholders’ equity. An ROE of 8.64% implies HK$0.09 returned on every HK$1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of PAX Global Technology’s equity capital deployed. Its cost of equity is 8.38%. While PAX Global Technology’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for PAX Global Technology which is encouraging. 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. Asset turnover reveals how much revenue can be generated from PAX Global Technology’s 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 ROE can be artificially increased through excessive borrowing, we should check PAX Global Technology’s historic debt-to-equity ratio. Currently PAX Global Technology has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why PAX Global Technology’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.