This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

With an ROE of 9.5%, SJM Holdings Limited (HKG:880) outpaced its own industry which delivered a less exciting 7.0% over the past year. While the impressive ratio tells us that 880 has made significant profits from little equity capital, ROE doesn’t tell us if 880 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 880’s ROE is actually sustainable.

View our latest analysis for SJM Holdings

Breaking down Return on Equity

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. 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

ROE is measured against cost of equity in order to determine the efficiency of SJM Holdings’s equity capital deployed. Its cost of equity is 16.4%. This means SJM Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -7.0%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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

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 SJM Holdings’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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt SJM Holdings currently has. Currently the debt-to-equity ratio stands at a reasonable 59.7%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. SJM Holdings’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.