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BaWang International (Group) Holding Limited (SEHK:1338) outperformed the Personal Products industry on the basis of its ROE – producing a higher 11.29% relative to the peer average of 8.38% over the past 12 months. Superficially, this looks great since we know that 1338 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 1338 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 1338’s ROE is. See our latest analysis for BaWang International (Group) Holding
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of BaWang International (Group) Holding’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 BaWang International (Group) Holding’s equity capital deployed. Its cost of equity is 8.38%. This means BaWang International (Group) Holding returns enough to cover its own cost of equity, with a buffer of 2.92%. 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
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 BaWang International (Group) Holding’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 BaWang International (Group) Holding’s debt-to-equity level. Currently, BaWang International (Group) Holding has no debt which means its returns are driven purely 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.