Nature Home Holding Company Limited (SEHK:2083) delivered a less impressive 1.83% ROE over the past year, compared to the 6.38% return generated by its industry. 2083’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 2083’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 2083’s returns. Let me show you what I mean by this. Check out our latest analysis for Nature Home Holding
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Nature Home Holding’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$0.02 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Nature Home Holding’s cost of equity is 8.38%. This means Nature Home Holding’s returns actually do not cover its own cost of equity, with a discrepancy of -6.55%. 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
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 Nature Home Holding 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 Nature Home Holding currently has. Currently the debt-to-equity ratio stands at a low 32.78%, which means Nature Home Holding still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Nature Home Holding’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Nature Home Holding’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.