Zall Group Ltd (SEHK:2098) delivered an ROE of 11.26% over the past 12 months, which is an impressive feat relative to its industry average of 10.60% during the same period. Superficially, this looks great since we know that 2098 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 2098 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 2098’s ROE is actually sustainable. View our latest analysis for Zall Group
Breaking down Return on Equity
Return on Equity (ROE) weighs 2098’s profit against the level of its shareholders’ equity. For example, if 2098 invests HK$1 in the form of equity, it will generate HK$0.11 in earnings from this. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for 2098, which is 8.38%. Given a positive discrepancy of 2.89% between return and cost, this indicates that 2098 pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient 2098 is with its cost management. Asset turnover reveals how much revenue can be generated from 2098’s 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 2098’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check 2098’s historic debt-to-equity ratio. At 54.82%, 2098’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? 2098’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 2098 to your portfolio if your personal research is confirming what the ROE is telling you. 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%.