I am writing today to help inform people who are new to the stock market and looking to gauge the potential return on investment in AAC Technologies Holdings Inc (HKG:2018).

AAC Technologies Holdings Inc (HKG:2018) outperformed the Electronic Manufacturing Services industry on the basis of its ROE – producing a higher 30.71% relative to the peer average of 10.79% over the past 12 months. Superficially, this looks great since we know that 2018 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 2018 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 2018’s ROE. See our latest analysis for AAC Technologies Holdings

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs AAC Technologies Holdings’s profit against the level of its shareholders’ equity. An ROE of 30.71% implies HK$0.31 returned on every HK$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 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 AAC Technologies Holdings, which is 8.44%. This means AAC Technologies Holdings returns enough to cover its own cost of equity, with a buffer of 22.27%. This sustainable practice implies that the company pays less 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from AAC Technologies Holdings’s 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 ROE can be inflated by excessive debt, we need to examine AAC Technologies Holdings’s debt-to-equity level. At 35.84%, AAC Technologies 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.