This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
Yuan Heng Gas Holdings Limited (HKG:332) outperformed the Oil and Gas Storage and Transportation industry on the basis of its ROE – producing a higher 12.0% relative to the peer average of 10.7% over the past 12 months. While the impressive ratio tells us that 332 has made significant profits from little equity capital, ROE doesn’t tell us if 332 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 332’s ROE is actually sustainable.
Check out our latest analysis for Yuan Heng Gas Holdings
What you must know about ROE
Return on Equity (ROE) weighs Yuan Heng Gas Holdings’s profit against the level of 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 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 Yuan Heng Gas Holdings, which is 11.6%. Given a positive discrepancy of 0.4% between return and cost, this indicates that Yuan Heng Gas Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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. Asset turnover shows how much revenue Yuan Heng Gas Holdings can generate with its current 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 Yuan Heng Gas Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 43.1%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.