China Literature Limited (SEHK:772) delivered a less impressive 0.63% ROE over the past year, compared to the 13.23% return generated by its industry. 772’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 772’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 772’s returns. Let me show you what I mean by this. See our latest analysis for 772
Breaking down Return on Equity
Return on Equity (ROE) is a measure of 772’s profit relative to its shareholders’ equity. It essentially shows how much 772 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
ROE is measured against cost of equity in order to determine the efficiency of 772’s equity capital deployed. Its cost of equity is 10.26%. Given a discrepancy of -9.63% between return and cost, this indicated that 772 may be paying more for its capital than what it’s generating 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from 772’s 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 772’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check 772’s historic debt-to-equity ratio. At 11.66%, 772’s debt-to-equity ratio appears low and indicates that 772 still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? 772’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 772 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%.