In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
NetDragon Websoft Holdings Limited (HKG:777) generated a below-average return on equity of 2.1% in the past 12 months, while its industry returned 9.0%. Though 777’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 777’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 777’s returns.
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What you must know about ROE
Return on Equity (ROE) is a measure of NetDragon Websoft Holdings’s profit relative to its shareholders’ equity. An ROE of 2.1% implies HK$0.021 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 NetDragon Websoft Holdings, which is 8.4%. Given a discrepancy of -6.3% between return and cost, this indicated that NetDragon Websoft Holdings may be paying more for its capital than what it’s generating in return. 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 the business is with its cost management. Asset turnover shows how much revenue NetDragon Websoft Holdings can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine NetDragon Websoft Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 11.1%, meaning NetDragon Websoft Holdings still has headroom to borrow debt to increase profits.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NetDragon Websoft Holdings exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.