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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Hing Lee (HK) Holdings Limited (HKG:396) delivered a less impressive 1.8% ROE over the past year, compared to the 12.1% return generated by its industry. Though 396’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 396’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 396’s returns.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Hing Lee (HK) Holdings’s profit relative to its shareholders’ equity. An ROE of 1.8% implies HK$0.018 returned on every HK$1 invested. 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 measured against cost of equity in order to determine the efficiency of Hing Lee (HK) Holdings’s equity capital deployed. Its cost of equity is 9.6%. Given a discrepancy of -7.8% between return and cost, this indicated that Hing Lee (HK) Holdings 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. Asset turnover reveals how much revenue can be generated from Hing Lee (HK) Holdings’s 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 the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Hing Lee (HK) Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 12.1%, meaning Hing Lee (HK) Holdings still has headroom to borrow debt to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Hing Lee (HK) Holdings’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Hing Lee (HK) Holdings’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.