In This Article:
I am writing today to help inform people who are new to the stock market and want to better understand how you can grow your money by investing in Shandong Xinhua Pharmaceutical Company Limited (HKG:719).
Shandong Xinhua Pharmaceutical Company Limited’s (HKG:719) most recent return on equity was a substandard 9.17% relative to its industry performance of 13.71% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 719’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 719’s returns. Let me show you what I mean by this. Check out our latest analysis for Shandong Xinhua Pharmaceutical
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 9.17% implies HK$0.092 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
ROE is measured against cost of equity in order to determine the efficiency of Shandong Xinhua Pharmaceutical’s equity capital deployed. Its cost of equity is 8.44%. Shandong Xinhua Pharmaceutical’s ROE exceeds its cost by 0.72%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than Shandong Xinhua Pharmaceutical’s case of positive discrepancy. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Shandong Xinhua Pharmaceutical’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 Shandong Xinhua Pharmaceutical’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 47.32%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.