With an ROE of 14.49%, Royal China International Holdings Limited (SEHK:1683) returned in-line to its own industry which delivered 16.69% over the past year. But what is more interesting is whether 1683 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 1683’s returns. Let me show you what I mean by this. See our latest analysis for Royal China International Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Royal China International Holdings’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Specialized Consumer Services 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
Returns are usually compared to costs to measure the efficiency of capital. Royal China International Holdings’s cost of equity is 17.11%. Since Royal China International Holdings’s return does not cover its cost, with a difference of -2.62%, this means its current use of equity is not efficient and not sustainable. Very simply, Royal China International 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Royal China International Holdings can generate with its current 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 Royal China International Holdings’s debt-to-equity ratio to examine sustainability of its returns. Currently, Royal China International Holdings has no debt which means its returns are driven purely by equity capital. This could explain why Royal China International Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Royal China International Holdings exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Royal China International 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 Royal China International Holdings, there are three relevant factors 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. Valuation: What is Royal China International 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 Royal China International Holdings is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Royal China 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!