This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.

With an ROE of 21.5%, Four Seas Mercantile Holdings Limited (HKG:374) outpaced its own industry which delivered a less exciting 9.4% over the past year. On the surface, this looks fantastic since we know that 374 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 374’s ROE is.

Check out our latest analysis for Four Seas Mercantile Holdings

What you must know about ROE

Return on Equity (ROE) weighs Four Seas Mercantile Holdings’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

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 Four Seas Mercantile Holdings, which is 12.1%. This means Four Seas Mercantile Holdings returns enough to cover its own cost of equity, with a buffer of 9.4%. This sustainable practice implies that the company 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 Four Seas Mercantile Holdings’s 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 Four Seas Mercantile Holdings’s debt-to-equity level. At 47.3%, Four Seas Mercantile Holdings’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.