New World Development Company Limited (SEHK:17) delivered a less impressive 4.97% ROE over the past year, compared to the 10.60% 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 17’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 17’s returns. View our latest analysis for New World Development

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of New World Development’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.05 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

ROE is measured against cost of equity in order to determine the efficiency of New World Development’s equity capital deployed. Its cost of equity is 13.23%. Since New World Development’s return does not cover its cost, with a difference of -8.27%, this means its current use of equity is not efficient and not sustainable. Very simply, New World Development pays more 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from New World Development’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 financial leverage can artificially inflate ROE, we need to look at how much debt New World Development currently has. At 66.87%, New World Development’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.

What this means for you:

Are you a shareholder? 17 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 17 still has room to improve shareholder returns by raising debt to fund new investments. 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%.