In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
China Lesso Group Holdings Limited (HKG:2128) outperformed the Building Products industry on the basis of its ROE – producing a higher 16.7% relative to the peer average of 5.1% over the past 12 months. On the surface, this looks fantastic since we know that 2128 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 2128’s ROE is.
View our latest analysis for China Lesso Group Holdings
Breaking down Return on Equity
Return on Equity (ROE) is a measure of China Lesso Group Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.17 in earnings from this. 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 China Lesso Group Holdings, which is 8.4%. Since China Lesso Group Holdings’s return covers its cost in excess of 8.2%, its use of equity capital is efficient and likely to be sustainable. Simply put, China Lesso Group Holdings pays less for its capital than what it generates in return. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue China Lesso Group Holdings can make from its 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 China Lesso Group Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 79.2%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.