This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
A-Living Services Co Ltd (HKG:3319) outperformed the Environmental and Facilities Services industry on the basis of its ROE – producing a higher 10.2% relative to the peer average of 9.7% over the past 12 months. Superficially, this looks great since we know that 3319 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 3319 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 3319’s ROE is.
Check out our latest analysis for A-Living Services
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
Returns are usually compared to costs to measure the efficiency of capital. A-Living Services’s cost of equity is 8.4%. This means A-Living Services returns enough to cover its own cost of equity, with a buffer of 1.7%. This sustainable practice implies that the company pays less for its capital than what it generates 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
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 A-Living Services 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 ROE can be artificially increased through excessive borrowing, we should check A-Living Services’s historic debt-to-equity ratio. Currently A-Living Services 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.