With an ROE of 9.05%, Somerley Capital Holdings Limited (SEHK:8439) outpaced its own industry which delivered a less exciting 8.97% over the past year. While the impressive ratio tells us that 8439 has made significant profits from little equity capital, ROE doesn’t tell us if 8439 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 8439’s ROE is. Check out our latest analysis for Somerley Capital Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Somerley Capital Holdings’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.09 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making 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 Somerley Capital Holdings, which is 8.38%. Given a positive discrepancy of 0.67% between return and cost, this indicates that Somerley Capital Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 reveals how much revenue can be generated from Somerley Capital Holdings’s 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 inflated by excessive debt, we need to examine Somerley Capital Holdings’s debt-to-equity level. Currently, Somerley Capital Holdings 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.
What this means for you:
Are you a shareholder? 8439 exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.