Allied Sustainability and Environmental Consultants Group Limited (SEHK:8320) delivered a less impressive 5.39% ROE over the past year, compared to the 8.43% 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 8320’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 8320’s returns. Check out our latest analysis for Allied Sustainability and Environmental Consultants Group
What you must know about ROE
Return on Equity (ROE) is a measure of Allied Sustainability and Environmental Consultants Group’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.05 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of Allied Sustainability and Environmental Consultants Group’s equity capital deployed. Its cost of equity is 8.38%. Given a discrepancy of -2.99% between return and cost, this indicated that Allied Sustainability and Environmental Consultants Group may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Allied Sustainability and Environmental Consultants Group can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Allied Sustainability and Environmental Consultants Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 1.93%, which means Allied Sustainability and Environmental Consultants Group still has headroom to take on more leverage in order to increase profits.