China Galaxy Securities Co Ltd (SEHK:6881) generated a below-average return on equity of 8.54% in the past 12 months, while its industry returned 8.97%. Though 6881’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 6881’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 6881’s returns. See our latest analysis for China Galaxy Securities
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs China Galaxy Securities’s profit against the level of its shareholders’ equity. An ROE of 8.54% implies HK$0.09 returned on every HK$1 invested. 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. China Galaxy Securities’s cost of equity is 11.12%. Since China Galaxy Securities’s return does not cover its cost, with a difference of -2.58%, this means its current use of equity is not efficient and not sustainable. Very simply, China Galaxy Securities pays more for its capital than what it generates in return. 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 China Galaxy Securities can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Galaxy Securities currently has. At 135.81%, China Galaxy Securities’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. China Galaxy Securities’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of China Galaxy Securities’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.