Sanroc International Holdings Limited (SEHK:1660) delivered an ROE of 7.45% over the past 12 months, which is relatively in-line with its industry average of 7.90% during the same period. But what is more interesting is whether 1660 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 1660’s returns. Let me show you what I mean by this. View our latest analysis for Sanroc International Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Sanroc International 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$0.07 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Trading Companies and Distributors 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.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Sanroc International Holdings’s equity capital deployed. Its cost of equity is 8.97%. This means Sanroc International Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -1.52%. 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
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 Sanroc International Holdings’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Sanroc International Holdings is fuelling ROE by excessively raising debt. Ideally, Sanroc International Holdings should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 25.05%, which is sensible and indicates Sanroc International Holdings has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Sanroc International Holdings still has room to increase leverage and grow future returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Sanroc International Holdings’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Sanroc International Holdings, I’ve put together three essential factors you should further examine:
- 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.
- Future Earnings: How does Sanroc International Holdings’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sanroc International Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!