This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Edvance International Holdings Limited (HKG:8410) outperformed the Technology Distributors industry on the basis of its ROE – producing a higher 19.6% relative to the peer average of 9.9% over the past 12 months. While the impressive ratio tells us that 8410 has made significant profits from little equity capital, ROE doesn’t tell us if 8410 has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 8410’s ROE.
See our latest analysis for Edvance International Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 19.6% implies HK$0.20 returned on every HK$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 Edvance International Holdings, which is 8.6%. Since Edvance International Holdings’s return covers its cost in excess of 11.0%, its use of equity capital is efficient and likely to be sustainable. Simply put, Edvance International Holdings pays less 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Edvance International Holdings can make from its 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 Edvance International Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 20.9%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.