YY Inc (NASDAQ:YY) delivered an ROE of 25.57% over the past 12 months, which is an impressive feat relative to its industry average of 12.85% during the same period. On the surface, this looks fantastic since we know that YY has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable YY’s ROE is. Check out our latest analysis for YY

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 25.57% implies $0.26 returned on every $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 YY’s equity capital deployed. Its cost of equity is 11.99%. Since YY’s return covers its cost in excess of 13.58%, its use of equity capital is efficient and likely to be sustainable. Simply put, YY pays less for its capital than what it generates 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 reveals how much revenue can be generated from YY’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 ROE can be inflated by excessive debt, we need to examine YY’s debt-to-equity level. Currently YY has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.

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. YY’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.