With an ROE of 46.36%, Taste Gourmet Group Limited (SEHK:8371) outpaced its own industry which delivered a less exciting 7.27% over the past year. Superficially, this looks great since we know that 8371 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 8371 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 8371’s ROE is. View our latest analysis for Taste Gourmet Group
What you must know about ROE
Return on Equity (ROE) is a measure of Taste Gourmet Group’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.46 in earnings from this. 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 Taste Gourmet Group, which is 14.78%. This means Taste Gourmet Group returns enough to cover its own cost of equity, with a buffer of 31.59%. This sustainable practice implies that the company 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
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 Taste Gourmet Group 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 Taste Gourmet Group’s historic debt-to-equity ratio. At 217.06%, Taste Gourmet Group’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.