North Asia Strategic Holdings Limited (SEHK:8080) generated a below-average return on equity of 9.47% in the past 12 months, while its industry returned 9.54%. Though 8080’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 8080’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 8080’s returns. Let me show you what I mean by this. View our latest analysis for North Asia Strategic Holdings
What you must know about ROE
Return on Equity (ROE) weighs North Asia Strategic Holdings’s profit against the level of its shareholders’ equity. It essentially shows how much the company 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. North Asia Strategic Holdings’s cost of equity is 8.38%. Some of North Asia Strategic Holdings’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for North Asia Strategic Holdings which is reassuring. 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 shows how much revenue North Asia Strategic 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 North Asia Strategic Holdings currently has. Currently, North Asia Strategic Holdings has no debt which means its returns are driven purely by equity capital. This could explain why North Asia Strategic Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.