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Soundwill Holdings Limited (SEHK:878) delivered a less impressive 6.04% ROE over the past year, compared to the 9.48% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 878’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 878’s returns. Check out our latest analysis for Soundwill Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Soundwill Holdings’s profit against the level of its shareholders’ equity. An ROE of 6.04% implies HK$0.06 returned on every HK$1 invested. 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 Soundwill Holdings, which is 9.24%. Since Soundwill Holdings’s return does not cover its cost, with a difference of -3.20%, this means its current use of equity is not efficient and not sustainable. Very simply, Soundwill Holdings pays more 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. Asset turnover shows how much revenue Soundwill Holdings 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 Soundwill Holdings currently has. Currently the debt-to-equity ratio stands at a low 7.68%, which means Soundwill Holdings still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Soundwill Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.