I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.

With an ROE of 20.4%, China Gas Holdings Limited (HKG:384) outpaced its own industry which delivered a less exciting 10.0% over the past year. While the impressive ratio tells us that 384 has made significant profits from little equity capital, ROE doesn’t tell us if 384 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 384’s ROE is actually sustainable.

View our latest analysis for China Gas Holdings

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of China Gas Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.20 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

Returns are usually compared to costs to measure the efficiency of capital. China Gas Holdings’s cost of equity is 9.6%. Since China Gas Holdings’s return covers its cost in excess of 10.8%, its use of equity capital is efficient and likely to be sustainable. Simply put, China Gas Holdings 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

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 China Gas Holdings can generate with its current 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 China Gas Holdings currently has. At 98.9%, China Gas Holdings’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

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. China Gas Holdings’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.