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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Logan Property Holdings Company Limited (HKG:3380) outperformed the Real Estate Development industry on the basis of its ROE – producing a higher 22.8% relative to the peer average of 9.3% over the past 12 months. Superficially, this looks great since we know that 3380 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 3380 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 3380’s ROE is.
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Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Logan Property Holdings’s profit against the level of its shareholders’ equity. An ROE of 22.8% implies HK$0.23 returned on every HK$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Logan Property Holdings’s cost of equity is 12.2%. Since Logan Property Holdings’s return covers its cost in excess of 10.6%, its use of equity capital is efficient and likely to be sustainable. Simply put, Logan Property Holdings 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 shows how much revenue Logan Property Holdings can generate with its current 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 Logan Property Holdings’s debt-to-equity level. At 156%, Logan Property Holdings’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
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ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Logan Property Holdings exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Logan Property Holdings’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.