KNK Holdings Limited (SEHK:8039) delivered an ROE of 20.74% over the past 12 months, which is an impressive feat relative to its industry average of 8.05% during the same period. Superficially, this looks great since we know that 8039 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 8039 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 8039’s ROE is actually sustainable. Check out our latest analysis for KNK Holdings
Breaking down Return on Equity
Return on Equity (ROE) weighs KNK 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. 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 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 KNK Holdings, which is 13.58%. This means KNK Holdings returns enough to cover its own cost of equity, with a buffer of 7.16%. This sustainable practice implies that the company 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
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 shows how much revenue KNK Holdings can generate with its current 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 artificially increased through excessive borrowing, we should check KNK Holdings’s historic debt-to-equity ratio. Currently, KNK Holdings 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.