In This Article:
Milestone Builder Holdings Limited’s (SEHK:1667) most recent return on equity was a substandard 5.94% relative to its industry performance of 12.24% over the past year. Though 1667’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 1667’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 1667’s returns. See our latest analysis for Milestone Builder Holdings
What you must know about ROE
Return on Equity (ROE) weighs Milestone Builder Holdings’s profit against the level of its shareholders’ equity. An ROE of 5.94% implies HK$0.06 returned on every HK$1 invested. 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. Milestone Builder Holdings’s cost of equity is 8.38%. Since Milestone Builder Holdings’s return does not cover its cost, with a difference of -2.43%, this means its current use of equity is not efficient and not sustainable. Very simply, Milestone Builder Holdings pays more for its capital than what it generates 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. Asset turnover shows how much revenue Milestone Builder Holdings can generate with its current 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 inflated by excessive debt, we need to examine Milestone Builder Holdings’s debt-to-equity level. At 35.94%, Milestone Builder Holdings’s debt-to-equity ratio appears low and indicates that Milestone Builder Holdings still has room to increase leverage and grow its profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Milestone Builder Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.