Hong Kong Ferry (Holdings) Company Limited’s (SEHK:50) most recent return on equity was a substandard 4.89% relative to its industry performance of 10.60% over the past year. 50’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 50’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 50’s returns. View our latest analysis for Hong Kong Ferry (Holdings)

Breaking down Return on Equity

Return on Equity (ROE) weighs Hong Kong Ferry (Holdings)’s profit against the level of its shareholders’ equity. An ROE of 4.89% implies HK$0.05 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

ROE is measured against cost of equity in order to determine the efficiency of Hong Kong Ferry (Holdings)’s equity capital deployed. Its cost of equity is 8.38%. This means Hong Kong Ferry (Holdings)’s returns actually do not cover its own cost of equity, with a discrepancy of -3.49%. This isn’t sustainable as it implies, very simply, that the company pays more 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Hong Kong Ferry (Holdings) can generate with its current 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 Hong Kong Ferry (Holdings) currently has. Currently, Hong Kong Ferry (Holdings) has no debt which means its returns are driven purely by equity capital. This could explain why Hong Kong Ferry (Holdings)’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.