In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Sunny Optical Technology (Group) Company Limited (HKG:2382) delivered an ROE of 36.7% over the past 12 months, which is an impressive feat relative to its industry average of 9.9% during the same period. Superficially, this looks great since we know that 2382 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 2382 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 2382’s ROE.
See our latest analysis for Sunny Optical Technology (Group)
Breaking down Return on Equity
Return on Equity (ROE) weighs Sunny Optical Technology (Group)’s profit against the level of 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
Returns are usually compared to costs to measure the efficiency of capital. Sunny Optical Technology (Group)’s cost of equity is 8.4%. This means Sunny Optical Technology (Group) returns enough to cover its own cost of equity, with a buffer of 28.3%. This sustainable practice implies that the company pays less for its capital than what it generates 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Sunny Optical Technology (Group)’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 Sunny Optical Technology (Group)’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 67.6%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.