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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Shenguan Holdings (Group) Limited (HKG:829) generated a below-average return on equity of 2.3% in the past 12 months, while its industry returned 10.6%. 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 829’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 829’s returns.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Shenguan Holdings (Group)’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
Returns are usually compared to costs to measure the efficiency of capital. Shenguan Holdings (Group)’s cost of equity is 9.5%. Since Shenguan Holdings (Group)’s return does not cover its cost, with a difference of -7.2%, this means its current use of equity is not efficient and not sustainable. Very simply, Shenguan Holdings (Group) 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Shenguan Holdings (Group) 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 inflated by excessive debt, we need to examine Shenguan Holdings (Group)’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 2.9%, which means Shenguan Holdings (Group) still has headroom to take on more leverage in order to increase profits.