Playmates Toys Limited’s (SEHK:869) most recent return on equity was a substandard 4.57% relative to its industry performance of 10.37% over the past year. 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 869’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 869’s returns. Let me show you what I mean by this. View our latest analysis for Playmates Toys

What you must know about ROE

Return on Equity (ROE) weighs Playmates Toys’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$0.05 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 Playmates Toys’s equity capital deployed. Its cost of equity is 9.40%. Given a discrepancy of -4.83% between return and cost, this indicated that Playmates Toys 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

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 Playmates Toys can generate with its current 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 Playmates Toys’s debt-to-equity level. Currently Playmates Toys has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Playmates Toys’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

What this means for you:

Are you a shareholder? 869’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 869 still has room to improve shareholder returns by raising debt to fund new investments. 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%.