With an ROE of 13.13%, CCID Consulting Company Limited (SEHK:8235) outpaced its own industry which delivered a less exciting 12.56% over the past year. While the impressive ratio tells us that 8235 has made significant profits from little equity capital, ROE doesn’t tell us if 8235 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 8235’s ROE is. Check out our latest analysis for CCID Consulting
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. CCID Consulting’s cost of equity is 9.70%. Since CCID Consulting’s return covers its cost in excess of 3.43%, its use of equity capital is efficient and likely to be sustainable. Simply put, CCID Consulting pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 reveals how much revenue can be generated from CCID Consulting’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check CCID Consulting’s historic debt-to-equity ratio. Currently, CCID Consulting has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. CCID Consulting’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.