Tsim Sha Tsui Properties Limited’s (SEHK:247) most recent return on equity was a substandard 6.47% relative to its industry performance of 10.60% over the past year. 247’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 247’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 247’s returns. View our latest analysis for Tsim Sha Tsui Properties

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Tsim Sha Tsui Properties’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Tsim Sha Tsui Properties’s equity capital deployed. Its cost of equity is 8.38%. Since Tsim Sha Tsui Properties’s return does not cover its cost, with a difference of -1.91%, this means its current use of equity is not efficient and not sustainable. Very simply, Tsim Sha Tsui Properties pays more for its capital than what it generates in return. 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Tsim Sha Tsui Properties 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 artificially increased through excessive borrowing, we should check Tsim Sha Tsui Properties’s historic debt-to-equity ratio. At 6.54%, Tsim Sha Tsui Properties’s debt-to-equity ratio appears low and indicates that Tsim Sha Tsui Properties still has room to increase leverage and grow its profits.

What this means for you:

Are you a shareholder? 247’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 247 still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.

Are you a potential investor? If you are considering investing in 247, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Tsim Sha Tsui Properties to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.