In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
SOHO China Limited’s (HKG:410) most recent return on equity was a substandard 5.4% relative to its industry performance of 9.3% over the past year. 410’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 410’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 410’s returns.
View our latest analysis for SOHO China
What you must know about ROE
Return on Equity (ROE) is a measure of SOHO China’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.054 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. SOHO China’s cost of equity is 13.2%. Since SOHO China’s return does not cover its cost, with a difference of -7.8%, this means its current use of equity is not efficient and not sustainable. Very simply, SOHO China 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from SOHO China’s 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 SOHO China currently has. Currently the debt-to-equity ratio stands at a reasonable 54.0%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.