Kina Securities Limited (ASX:KSL) outperformed the Other Diversified Financial Services industry on the basis of its ROE – producing a higher 9.45% relative to the peer average of 9.44% over the past 12 months. While the impressive ratio tells us that KSL has made significant profits from little equity capital, ROE doesn’t tell us if KSL has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of KSL’s ROE. Check out our latest analysis for Kina Securities
Breaking down Return on Equity
Return on Equity (ROE) weighs KSL’s profit against the level of its shareholders’ equity. It essentially shows how much KSL can generate in earnings given the amount of equity it has raised. 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
Returns are usually compared to costs to measure the efficiency of capital. KSL’s cost of equity is 10.56%. Given a discrepancy of -1.11% between return and cost, this indicated that KSL 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. Asset turnover reveals how much revenue can be generated from KSL’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt KSL currently has. Currently KSL has virtually no debt, which means its returns are predominantly driven 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.
What this means for you:
Are you a shareholder? KSL’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as KSL still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.