This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

With an ROE of 37.2%, FSE Services Group Limited (HKG:331) outpaced its own industry which delivered a less exciting 11.6% over the past year. While the impressive ratio tells us that 331 has made significant profits from little equity capital, ROE doesn’t tell us if 331 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 331’s ROE is.

View our latest analysis for FSE Services Group

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs FSE Services Group’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$0.37 in earnings from this. 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

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 FSE Services Group, which is 8.4%. This means FSE Services Group returns enough to cover its own cost of equity, with a buffer of 28.7%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be broken down into three different 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 FSE Services 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 financial leverage can artificially inflate ROE, we need to look at how much debt FSE Services Group currently has. Currently, FSE Services Group 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.