Yuexiu Property Company Limited (SEHK:123) delivered a less impressive 5.90% ROE over the past year, compared to the 10.60% return generated by its industry. 123’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 123’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 123’s returns. See our latest analysis for Yuexiu Property
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.06 in earnings from this. 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. Yuexiu Property’s cost of equity is 18.12%. This means Yuexiu Property’s returns actually do not cover its own cost of equity, with a discrepancy of -12.22%. 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. The other component, asset turnover, illustrates how much revenue Yuexiu Property can make from its 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 Yuexiu Property currently has. The debt-to-equity ratio currently stands at a balanced 126.24%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? 123 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 123 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.