In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Extrawell Pharmaceutical Holdings Limited’s (HKG:858) most recent return on equity was a substandard 2.7% relative to its industry performance of 12.7% over the past year. 858’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 858’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 858’s returns. Let me show you what I mean by this.
See our latest analysis for Extrawell Pharmaceutical 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$0.027 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 Extrawell Pharmaceutical Holdings’s equity capital deployed. Its cost of equity is 8.4%. This means Extrawell Pharmaceutical Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -5.7%. 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 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Extrawell Pharmaceutical Holdings can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Extrawell Pharmaceutical Holdings currently has. The debt-to-equity ratio currently stands at a low 5.8%, meaning Extrawell Pharmaceutical Holdings still has headroom to borrow debt to increase profits.