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Link Holdings Limited’s (SEHK:8237) most recent return on equity was a substandard 2.34% relative to its industry performance of 7.37% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 8237’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 8237’s returns. View our latest analysis for Link Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Link Holdings’s profit relative to its shareholders’ equity. An ROE of 2.34% implies HK$0.02 returned on every HK$1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Link Holdings’s cost of equity is 14.81%. Given a discrepancy of -12.47% between return and cost, this indicated that Link Holdings may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Link Holdings can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Link Holdings currently has. At 44.62%, Link Holdings’s debt-to-equity ratio appears low and indicates that Link Holdings still has room to increase leverage and grow its profits.
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. Link Holdings’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.