This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Asia Tele-Net and Technology Corporation Limited (HKG:679) outperformed the Industrial Machinery industry on the basis of its ROE – producing a higher 11.8% relative to the peer average of 9.7% over the past 12 months. While the impressive ratio tells us that 679 has made significant profits from little equity capital, ROE doesn’t tell us if 679 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 679’s ROE is actually sustainable.
Check out our latest analysis for Asia Tele-Net and Technology
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
Returns are usually compared to costs to measure the efficiency of capital. Asia Tele-Net and Technology’s cost of equity is 10.4%. This means Asia Tele-Net and Technology returns enough to cover its own cost of equity, with a buffer of 1.4%. This sustainable practice implies that the company pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Asia Tele-Net and Technology can make from its 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 ROE can be artificially increased through excessive borrowing, we should check Asia Tele-Net and Technology’s historic debt-to-equity ratio. Currently, Asia Tele-Net and Technology has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.