The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on AAG Energy Holdings Limited (HKG:2686) stock.

AAG Energy Holdings Limited (HKG:2686) delivered a less impressive 3.70% ROE over the past year, compared to the 10.52% return generated by its industry. Though 2686’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 2686’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 2686’s returns. View out our latest analysis for AAG Energy Holdings

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 3.70% implies HK$0.037 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 measured against cost of equity in order to determine the efficiency of AAG Energy Holdings’s equity capital deployed. Its cost of equity is 11.08%. Given a discrepancy of -7.38% between return and cost, this indicated that AAG Energy Holdings may be paying more for its capital than what it’s generating 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

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 AAG Energy 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 artificially increased through excessive borrowing, we should check AAG Energy Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 10.38%, meaning AAG Energy Holdings still has headroom to borrow debt to increase profits.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. AAG Energy Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of AAG Energy Holdings’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.