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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
Top Spring International Holdings Limited (HKG:3688) outperformed the Real Estate Development industry on the basis of its ROE – producing a higher 40.5% relative to the peer average of 9.3% over the past 12 months. On the surface, this looks fantastic since we know that 3688 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 3688’s ROE.
Check out our latest analysis for Top Spring International Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Top Spring International Holdings’s profit against the level of its shareholders’ equity. An ROE of 40.5% implies HK$0.40 returned on every HK$1 invested. 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. Top Spring International Holdings’s cost of equity is 17.8%. Given a positive discrepancy of 22.7% between return and cost, this indicates that Top Spring International Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 Top Spring International 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 Top Spring International Holdings currently has. The debt-to-equity ratio currently stands at a sensible 83.6%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.