UBA Investments Limited (SEHK:768) delivered a less impressive 8.91% ROE over the past year, compared to the 8.97% 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 768’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 768’s returns. Let me show you what I mean by this. Check out our latest analysis for UBA Investments
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of UBA Investments’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 UBA Investments, which is 8.38%. Some of UBA Investments’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for UBA Investments which is reassuring. 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 UBA Investments can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check UBA Investments’s historic debt-to-equity ratio. Currently, UBA Investments has no debt which means its returns are driven purely by equity capital. This could explain why UBA Investments’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.