Will Hong Kong Finance Group Limited (HKG:1273) Continue To Underperform Its Industry?

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.

Hong Kong Finance Group Limited (HKG:1273) performed in line with its thrifts and mortgage finance industry on the basis of its ROE – producing a return of 9.3% relative to the peer average of 7.1% over the past 12 months. But what is more interesting is whether 1273 can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 1273's returns. Let me show you what I mean by this.

Check out our latest analysis for Hong Kong Finance Group

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.093 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Thrifts and Mortgage Finance sector by investing in the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.

Returns are usually compared to costs to measure the efficiency of capital. Hong Kong Finance Group’s cost of equity is 8.4%. Some of Hong Kong Finance Group’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Hong Kong Finance Group which is reassuring. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Hong Kong Finance Group’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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Hong Kong Finance Group’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 103%, which is relatively balanced. This means Hong Kong Finance Group has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Even though Hong Kong Finance Group returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Hong Kong Finance Group’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For Hong Kong Finance Group, I've put together three important factors you should look at:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Valuation: What is Hong Kong Finance Group worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Hong Kong Finance Group is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Hong Kong Finance Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.