With an ROE of 10.50%, Xinghua Port Holdings Ltd (SEHK:1990) outpaced its own industry which delivered a less exciting 10.11% over the past year. While the impressive ratio tells us that 1990 has made significant profits from little equity capital, ROE doesn’t tell us if 1990 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 1990’s ROE is. View our latest analysis for Xinghua Port Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Xinghua Port Holdings’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Xinghua Port Holdings’s cost of equity is 10.78%. This means Xinghua Port Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -0.28%. This isn’t sustainable as it implies, very simply, that the company 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
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 Xinghua Port Holdings can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Xinghua Port Holdings’s historic debt-to-equity ratio. At 75.37%, Xinghua Port Holdings’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Xinghua Port Holdings’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.