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Swire Pacific Limited (SEHK:19) delivered an ROE of 10.58% over the past 12 months, which is an impressive feat relative to its industry average of 9.39% during the same period. While the impressive ratio tells us that 19 has made significant profits from little equity capital, ROE doesn’t tell us if 19 has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 19’s ROE. See our latest analysis for Swire Pacific
What you must know about ROE
Return on Equity (ROE) is a measure of Swire Pacific’s profit relative to its shareholders’ equity. An ROE of 10.58% implies HK$0.11 returned on every HK$1 invested. 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 Swire Pacific, which is 10.84%. This means Swire Pacific’s returns actually do not cover its own cost of equity, with a discrepancy of -0.26%. 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 dissected into three distinct 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 Swire Pacific 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 ROE can be artificially increased through excessive borrowing, we should check Swire Pacific’s historic debt-to-equity ratio. At 25.89%, Swire Pacific’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.