I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.

Tongda Group Holdings Limited (HKG:698) delivered an ROE of 18.1% over the past 12 months, which is an impressive feat relative to its industry average of 11.0% during the same period. While the impressive ratio tells us that 698 has made significant profits from little equity capital, ROE doesn’t tell us if 698 has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 698’s ROE.

See our latest analysis for Tongda Group 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. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.18 in earnings from this. 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 Tongda Group Holdings, which is 11.0%. Since Tongda Group Holdings’s return covers its cost in excess of 7.1%, its use of equity capital is efficient and likely to be sustainable. Simply put, Tongda Group Holdings pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue Tongda 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 Tongda Group Holdings’s debt-to-equity level. At 64.6%, Tongda Group Holdings’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.