Neway Group Holdings Limited (SEHK:55) generated a below-average return on equity of 4.75% in the past 12 months, while its industry returned 9.42%. 55’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 55’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 55’s returns. Check out our latest analysis for Neway Group Holdings
Peeling the layers of ROE – trisecting a company’s profitability
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$0.05 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Commercial Printing 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 Neway Group 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. Neway Group Holdings’s cost of equity is 10.00%. Since Neway Group Holdings’s return does not cover its cost, with a difference of -5.25%, this means its current use of equity is not efficient and not sustainable. Very simply, Neway Group 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:
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 Neway Group Holdings can generate with its current 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. 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 Neway Group Holdings’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 6.08%, which is sensible and indicates Neway Group Holdings has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Neway Group Holdings still has room to increase leverage and grow future returns.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Neway Group 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. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Neway Group Holdings’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Neway Group Holdings, I’ve compiled three key factors you should further research:
- 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 Neway Group 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 Neway Group 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!