The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Li Bao Ge Group Limited (HKG:8102) delivered an ROE of 15.90% over the past 12 months, which is an impressive feat relative to its industry average of 7.95% during the same period. While the impressive ratio tells us that 8102 has made significant profits from little equity capital, ROE doesn’t tell us if 8102 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 8102’s ROE is actually sustainable.
Check out our latest analysis for Li Bao Ge Group
Breaking down Return on Equity
Return on Equity (ROE) weighs Li Bao Ge Group’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.16 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. Li Bao Ge Group’s cost of equity is 13.76%. This means Li Bao Ge Group returns enough to cover its own cost of equity, with a buffer of 2.14%. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Li Bao Ge Group’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Li Bao Ge Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 10.43%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Li Bao Ge Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.