In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Pak Fah Yeow International Limited’s (HKG:239) most recent return on equity was a substandard 8.9% relative to its industry performance of 12.7% over the past year. 239’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 239’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 239’s returns. Let me show you what I mean by this.
View our latest analysis for Pak Fah Yeow International
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Pak Fah Yeow International’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.089 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
Returns are usually compared to costs to measure the efficiency of capital. Pak Fah Yeow International’s cost of equity is 8.4%. Some of Pak Fah Yeow International’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Pak Fah Yeow International which is reassuring. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Pak Fah Yeow International can make from its 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 Pak Fah Yeow International currently has. The debt-to-equity ratio currently stands at a low 3.3%, meaning Pak Fah Yeow International still has headroom to borrow debt to increase profits.