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With an ROE of 11.57%, Tian Ge Interactive Holdings Limited (SEHK:1980) outpaced its own industry which delivered a less exciting 10.54% over the past year. While the impressive ratio tells us that 1980 has made significant profits from little equity capital, ROE doesn’t tell us if 1980 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 1980’s ROE is actually sustainable. See our latest analysis for Tian Ge Interactive Holdings
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Tian Ge Interactive Holdings’s profit relative to its shareholders’ equity. An ROE of 11.57% implies HK$0.12 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
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 Tian Ge Interactive Holdings, which is 11.20%. Given a positive discrepancy of 0.37% between return and cost, this indicates that Tian Ge Interactive Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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. Asset turnover reveals how much revenue can be generated from Tian Ge Interactive Holdings’s 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 Tian Ge Interactive Holdings’s debt-to-equity level. Currently, Tian Ge Interactive 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.