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.
Gold Peak Industries (Holdings) Limited (HKG:40) generated a below-average return on equity of 4.68% in the past 12 months, while its industry returned 10.59%. 40'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 40’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 40's returns.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Gold Peak Industries (Holdings)’s profit relative to its shareholders’ equity. An ROE of 4.68% implies HK$0.047 returned on every HK$1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Electronic Components 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 Gold Peak Industries (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
ROE is measured against cost of equity in order to determine the efficiency of Gold Peak Industries (Holdings)’s equity capital deployed. Its cost of equity is 17.80%. This means Gold Peak Industries (Holdings)’s returns actually do not cover its own cost of equity, with a discrepancy of -13.12%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue Gold Peak Industries (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. 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 Gold Peak Industries (Holdings)’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 134.80%, which is relatively balanced. This means Gold Peak Industries (Holdings) has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Gold Peak Industries (Holdings)’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Gold Peak Industries (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.
- Future Earnings: How does Gold Peak Industries (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 Gold Peak Industries (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.
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Simply Wall St has no position in any of the companies mentioned. This article is general in nature. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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