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.
Truly International Holdings Limited (HKG:732) delivered a less impressive 4.7% ROE over the past year, compared to the 10.4% 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 732’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 732’s returns.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Truly International Holdings’s profit against the level of its shareholders’ equity. An ROE of 4.7% implies HK$0.047 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
Returns are usually compared to costs to measure the efficiency of capital. Truly International Holdings’s cost of equity is 17.1%. This means Truly International Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -12.4%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be broken down into three different 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 Truly International Holdings 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Truly International Holdings currently has. Currently the debt-to-equity ratio stands at a balanced 104%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.