Gold Peak Industries (Holdings) Limited (SEHK:40) generated a below-average return on equity of 4.62% in the past 12 months, while its industry returned 13.74%. Though 40’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 40’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 40’s returns. See our latest analysis for 40
What you must know about ROE
Return on Equity (ROE) is a measure of 40’s profit relative to its shareholders’ equity. For example, if 40 invests HK$1 in the form of equity, it will generate HK$0.05 in earnings from this. Investors seeking to maximise their return in the Electronic Components industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. 40’s cost of equity is 18.12%. Given a discrepancy of -13.50% between return and cost, this indicated that 40 may be paying more for its capital than what it’s generating 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. Asset turnover reveals how much revenue can be generated from 40’s 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 40’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a balanced 103.74%, meaning 40 has not taken on excessively disproportionate debt to drive its returns. The company is able to produce profit growth without a substantial debt burden.
ROE – More than just a profitability ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. 40’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 40’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 Gold Peak Industries (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. Future Earnings: How does 40’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.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of 40? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!