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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 looking to gauge the potential return on investment in Public Financial Holdings Limited (HKG:626).
Public Financial Holdings Limited (HKG:626) delivered a less impressive 6.61% ROE over the past year, compared to the 11.70% return generated by its industry. Though 626’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 626’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 626’s returns. Check out our latest analysis for Public Financial Holdings
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 6.61% implies HK$0.066 returned on every HK$1 invested. 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 measured against cost of equity in order to determine the efficiency of Public Financial Holdings’s equity capital deployed. Its cost of equity is 9.86%. This means Public Financial Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -3.25%. 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 broken down into three different 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 Public Financial 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 Public Financial Holdings currently has. At 20.78%, Public Financial Holdings’s debt-to-equity ratio appears low and indicates that Public Financial Holdings still has room to increase leverage and grow its profits.