This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Zioncom Holdings Limited (HKG:8287) delivered a less impressive 1.0% ROE over the past year, compared to the 11.4% return generated by its industry. 8287’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 8287’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 8287’s returns.
View our latest analysis for Zioncom Holdings
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Zioncom Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.0099 in earnings from this. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Zioncom Holdings, which is 12.7%. Since Zioncom Holdings’s return does not cover its cost, with a difference of -11.7%, this means its current use of equity is not efficient and not sustainable. Very simply, Zioncom Holdings 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
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 Zioncom Holdings 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 artificially increased through excessive borrowing, we should check Zioncom Holdings’s historic debt-to-equity ratio. At 30.5%, Zioncom Holdings’s debt-to-equity ratio appears low and indicates that Zioncom Holdings still has room to increase leverage and grow its profits.