With an ROE of 3.31%, Link Holdings Limited (SEHK:8237) outpaced its own industry which delivered a less exciting 1.65% over the past year. Superficially, this looks great since we know that 8237 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 8237 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 8237’s ROE is. See our latest analysis for Link 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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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

Returns are usually compared to costs to measure the efficiency of capital. Link Holdings’s cost of equity is 16.75%. Given a discrepancy of -13.44% between return and cost, this indicated that Link Holdings may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Link Holdings’s 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 artificially increased through excessive borrowing, we should check Link Holdings’s historic debt-to-equity ratio. At 46.44%, Link Holdings’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

What this means for you:

Are you a shareholder? 8237 exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 8237 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.