Harmonicare Medical Holdings Limited’s (SEHK:1509) most recent return on equity was a substandard 4.92% relative to its industry performance of 10.70% over the past year. 1509’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 1509’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 1509’s returns. Check out our latest analysis for Harmonicare Medical Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of 1509’s profit relative to its shareholders’ equity. It essentially shows how much 1509 can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Healthcare Facilities industry may want to choose 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 1509 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
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 1509, which is 8.38%. Since 1509’s return does not cover its cost, with a difference of -3.45%, this means its current use of equity is not efficient and not sustainable. Very simply, 1509 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from 1509’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if 1509’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 1509’s debt-to-equity ratio. Currently 1509 has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why 1509’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE – It’s not just another ratio
ROE is a relatively simple calculation, but it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. 1509’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 1509’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 Harmonicare Medical Holdings, there are three important factors you should further examine:
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 1509 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 1509 is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of 1509? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!