Sino Hotels (Holdings) Limited (SEHK:1221) delivered an ROE of 4.09% over the past 12 months, which is an impressive feat relative to its industry average of 1.65% during the same period. On the surface, this looks fantastic since we know that 1221 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 1221’s ROE is. View our latest analysis for Sino Hotels (Holdings)
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 4.09% implies HK$0.04 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
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 Sino Hotels (Holdings), which is 15.75%. This means Sino Hotels (Holdings)’s returns actually do not cover its own cost of equity, with a discrepancy of -11.66%. This isn’t sustainable as it implies, very simply, that the company pays more 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 Sino Hotels (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 Sino Hotels (Holdings)’s debt-to-equity level. Currently, Sino Hotels (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.
What this means for you:
Are you a shareholder? 1221’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 1221 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.