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I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 12.3%, Tenfu (Cayman) Holdings Company Limited (HKG:6868) outpaced its own industry which delivered a less exciting 11.0% over the past year. While the impressive ratio tells us that 6868 has made significant profits from little equity capital, ROE doesn’t tell us if 6868 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 6868’s ROE is.
View our latest analysis for Tenfu (Cayman) Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Tenfu (Cayman) Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.12 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 measured against cost of equity in order to determine the efficiency of Tenfu (Cayman) Holdings’s equity capital deployed. Its cost of equity is 9.2%. This means Tenfu (Cayman) Holdings returns enough to cover its own cost of equity, with a buffer of 3.1%. 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 Tenfu (Cayman) Holdings can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Tenfu (Cayman) Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 14.0%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Tenfu (Cayman) Holdings exhibits a strong ROE against its peers, as well as sufficient returns to cover 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.