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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Yue Da Mining Holdings Limited (HKG:629) delivered a less impressive 8.3% ROE over the past year, compared to the 10.7% return generated by its industry. Though 629’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 629’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 629’s returns.
Check out our latest analysis for Yue Da Mining 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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
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 Yue Da Mining Holdings, which is 10.9%. Given a discrepancy of -2.7% between return and cost, this indicated that Yue Da Mining Holdings 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Yue Da Mining 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 Yue Da Mining Holdings currently has. At 126%, Yue Da Mining Holdings’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.