This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
China All Access (Holdings) Limited (HKG:633) generated a below-average return on equity of 5.7% in the past 12 months, while its industry returned 11.4%. 633’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 633’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 633’s returns.
View our latest analysis for China All Access (Holdings)
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of China All Access (Holdings)’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.057 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of China All Access (Holdings)’s equity capital deployed. Its cost of equity is 17.8%. Since China All Access (Holdings)’s return does not cover its cost, with a difference of -12.1%, this means its current use of equity is not efficient and not sustainable. Very simply, China All Access (Holdings) pays more for its capital than what it generates in return. 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 shows how much revenue China All Access (Holdings) can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine China All Access (Holdings)’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 38.8%, which means China All Access (Holdings) still has headroom to take on more leverage in order to increase profits.