The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and looking to gauge the potential return on investment in Lam Soon (Hong Kong) Limited (HKG:411).

With an ROE of 14.09%, Lam Soon (Hong Kong) Limited (HKG:411) outpaced its own industry which delivered a less exciting 9.69% over the past year. Superficially, this looks great since we know that 411 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 411 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 411’s ROE is actually sustainable. Check out our latest analysis for Lam Soon (Hong Kong)

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 14.09% implies HK$0.14 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 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 Lam Soon (Hong Kong), which is 8.81%. This means Lam Soon (Hong Kong) returns enough to cover its own cost of equity, with a buffer of 5.28%. This sustainable practice implies that the company pays less 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

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 shows how much revenue Lam Soon (Hong Kong) can generate with its current 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 Lam Soon (Hong Kong)’s historic debt-to-equity ratio. Currently Lam Soon (Hong Kong) has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.