This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
With an ROE of 16.7%, Rare Earth Magnesium Technology Group Holdings Limited (HKG:601) outpaced its own industry which delivered a less exciting 12.1% over the past year. Superficially, this looks great since we know that 601 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 601 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 601’s ROE is.
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Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 16.7% implies HK$0.17 returned on every HK$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Rare Earth Magnesium Technology Group Holdings’s cost of equity is 9.9%. Since Rare Earth Magnesium Technology Group Holdings’s return covers its cost in excess of 6.9%, its use of equity capital is efficient and likely to be sustainable. Simply put, Rare Earth Magnesium Technology Group 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Rare Earth Magnesium Technology 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 Rare Earth Magnesium Technology Group Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 62.6%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.