I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Yue Yuen Industrial (Holdings) Limited (HKG:551) performed in line with its footwear industry on the basis of its ROE – producing a return of 9.7% relative to the peer average of 10.1% over the past 12 months. But what is more interesting is whether 551 can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 551’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Yue Yuen Industrial (Holdings)’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.097 in earnings from this. Investors seeking to maximise their return in the Footwear 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Yue Yuen Industrial (Holdings), which is 9.1%. Some of Yue Yuen Industrial (Holdings)’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 Yue Yuen Industrial (Holdings) 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:
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. The other component, asset turnover, illustrates how much revenue Yue Yuen Industrial (Holdings) can make from its 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. We can determine if Yue Yuen Industrial (Holdings)’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Yue Yuen Industrial (Holdings)’s debt-to-equity ratio. The most recent ratio is 48.6%, which is sensible and indicates Yue Yuen Industrial (Holdings) has not taken on too much leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a large debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Even though Yue Yuen Industrial (Holdings) 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 Yue Yuen Industrial (Holdings)’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 Yue Yuen Industrial (Holdings), 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 Yue Yuen Industrial (Holdings) 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 Yue Yuen Industrial (Holdings) is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Yue Yuen Industrial (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!
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.