This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
HengTen Networks Group Limited (HKG:136) delivered an ROE of 17.3% over the past 12 months, which is an impressive feat relative to its industry average of 10.1% during the same period. Though, the impressiveness of 136’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is 136’s financial leverage. If 136 borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface.
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$0.17 in earnings from this. Investors seeking to maximise their return in the Apparel, Accessories and Luxury Goods industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst 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 HengTen Networks Group’s equity capital deployed. Its cost of equity is 8.4%. Since HengTen Networks Group’s return covers its cost in excess of 8.9%, its use of equity capital is efficient and likely to be sustainable. Simply put, HengTen Networks Group pays less 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 HengTen Networks Group 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. We can assess whether HengTen Networks Group is fuelling ROE by excessively raising debt. Ideally, HengTen Networks Group 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 5.2%, which is sensible and indicates HengTen Networks Group has not taken on too much leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. HengTen Networks Group exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For HengTen Networks Group, I’ve put together 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.
- Valuation: What is HengTen Networks 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 HengTen Networks Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of HengTen Networks 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 firstname.lastname@example.org.