Is Prosper Construction Holdings Limited’s (HKG:6816) ROE Of 12.78% Sustainable?

I am writing today to help inform people who are new to the stock market and want to begin learning the link between Prosper Construction Holdings Limited (HKG:6816)’s return fundamentals and stock market performance.

Prosper Construction Holdings Limited (HKG:6816) delivered an ROE of 12.78% over the past 12 months, which is relatively in-line with its industry average of 11.41% during the same period. But what is more interesting is whether 6816 can sustain this level of return. This can be measured by looking at the company’s financial leverage. With more debt, 6816 can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. View out our latest analysis for Prosper Construction Holdings

Breaking down Return on Equity

Return on Equity (ROE) weighs Prosper Construction Holdings’s profit against the level of its shareholders’ equity. An ROE of 12.78% implies HK$0.13 returned on every HK$1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Construction and Engineering sector by investing in the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Prosper Construction Holdings has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. Prosper Construction Holdings’s cost of equity is 8.44%. This means Prosper Construction Holdings returns enough to cover its own cost of equity, with a buffer of 4.34%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be broken down into three different 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

SEHK:6816 Last Perf June 27th 18
SEHK:6816 Last Perf June 27th 18

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Prosper Construction Holdings can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 Prosper Construction Holdings’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 34.25%, which is very low. This means Prosper Construction Holdings has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.

SEHK:6816 Historical Debt June 27th 18
SEHK:6816 Historical Debt June 27th 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Prosper Construction Holdings’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Prosper Construction Holdings, I’ve put together three important aspects you should further research:

  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. Future Earnings: How does Prosper Construction 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.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Prosper Construction 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!