In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Kangda International Environmental Company Limited (HKG:6136) delivered an ROE of 10.2% over the past 12 months, which is an impressive feat relative to its industry average of 9.9% during the same period. Superficially, this looks great since we know that 6136 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 6136 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 6136’s ROE is.
View our latest analysis for Kangda International Environmental
Peeling the layers of ROE – trisecting a company’s profitability
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. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Kangda International Environmental, which is 17.8%. Given a discrepancy of -7.6% between return and cost, this indicated that Kangda International Environmental may be paying more for its capital than what it’s generating 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Kangda International Environmental 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 Kangda International Environmental currently has. Currently the debt-to-equity ratio stands at a high 209%, which means its above-average ROE is driven by significant debt levels.