Sing On Holdings Limited (SEHK:8352) outperformed the Construction and Engineering industry on the basis of its ROE – producing a higher 19.24% relative to the peer average of 14.50% over the past 12 months. While the impressive ratio tells us that 8352 has made significant profits from little equity capital, ROE doesn’t tell us if 8352 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 8352’s ROE is. See our latest analysis for 8352
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 19.24% implies HK$0.19 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 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 8352, which is 8.38%. Given a positive discrepancy of 10.87% between return and cost, this indicates that 8352 pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient 8352 is with its cost management. Asset turnover shows how much revenue 8352 can generate with its current 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 8352’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check 8352’s historic debt-to-equity ratio. Currently, 8352 has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? 8352’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 8352 to your portfolio if your personal research is confirming what the ROE is telling you. 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%.