The valuation levels of brokerages show a clear correlation with their profitabilityIn recent years, as the profitability of traditional brokerage services has declined, the business models of these firms have gradually shifted toward a heavier asset-based approachThis transition has led to a decrease in return on equity (ROE) elasticity across the industry, which in turn has constrained valuation flexibility while diminishing how sensitive these valuations are to market fluctuations.

Currently, a closer look at the distribution of stock valuations in the securities industry reveals a strong connection with the ROE levels of various firmsUsing data sourced from Wind, we analyzed the average ROE and price-to-book (PB) ratio of 50 publicly-listed brokerage firms over a six-year span from 2016 to 2021. The data indicates that those with higher ROE figures, such as Huayin Securities (11.96%), CITIC Securities (13.28%), and Dongfang Caifu (11.21%), also possess relatively high PB valuations of 7.51, 3.07, and 5.21, respectively

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This trend underscores the link between a firm’s profitability and its market valuation.

ROE, which measures a firm’s efficiency at generating profits from shareholders’ equity, is significantly influenced by the types of business activities conducted by brokeragesIncome streams from light-asset businesses, such as brokerage, investment banking, and asset management, generally yield higher ROE compared to heavier capital-intensive businessesThe disparity in the mix of these services among different brokerages creates variability in their ROE metrics, underlying one of the core reasons for performance differences across the industry.

Further insight into these ROE variations can be gleaned through a DuPont analysis of publicly-listed brokeragesAccording to the DuPont formula—ROE equals net profit margin times asset turnover times equity multiplier—an evaluation of the 2020 ROE figures reveals significant disparities among firms

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For example, Dongfang Caifu Securities boasted a net profit margin of 58%, while Huayin Securities followed closely with 55%, both far surpassing the average industry margin of 35%. Conversely, China International Capital Corporation (CICC) excelled in asset and liability management, achieving an equity multiplier of 7.23, which contributed to its overall ROE of 12.02%. This analytical framework offers valuable perspectives on the driving forces behind differing ROE levels.

Historically, the evolution of profit models among brokerages can be segmented into distinct phases that reflect broader market changesFrom a perspective presented by Caixin Securities, the period following comprehensive reforms in 2006 can be divided into three stages: 2006 to 2010, 2011 to 2015, and 2016 to 2021. During the initial phase, brokerages underwent rapid growth following reforms that addressed long-term risks and inefficiencies, leading to rising profitability with a peak annual ROE of 38.69% in the bull market of 2007.

In examining the business structures from 2006 to 2010, it becomes apparent that brokerages operated primarily on a light-asset model, with brokerage services dominating revenue streams, particularly in a time when average commission rates were significantly higher than today

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Data from 2007 to 2010 illustrates these commission rates peaking at levels that would seem extravagant by today’s standard, providing considerable room for profitability in brokerage operations.

The second phase began in 2012, marked by an innovative spirit spurred by an industry conference that catalyzed new business developments amid declining commission ratesBrokerages began shifting towards heavier asset classes creating more complex financial products, thus diversifying revenue sources as interest income began to become prevalent in firm revenuesA stunning escalation of asset management services occurred, with managed assets soaring from approximately 1.89 trillion yuan in 2012 to over 17.58 trillion yuan by 2016, reflecting a compounded annual growth rate of 75% despite the low profitability margins characteristic of fixed-income products.

Despite these advancements, 2014 heralded a competitive landscape shift as new brokerage firms introduced low-commission products, intensifying the prevailing commission price war

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Coupled with gradual deregulation efforts, this environment saw brokerage revenues driven increasingly by user activity rather than asset managementThe robust performance of the market from 2011 to 2015 translated into an industry-wide average ROE as high as 16.86% during the peak years of this period.

Since 2016, further accelerated asset-heavy transformations have become apparent, with self-operated business scales expanding at a compound annual growth rate of 23.11%. The nature of investments gradually shifted toward fixed-income securities, leading to a reduction in stock investments, while brokerage businesses, once the mainstay of revenue, now comprise only a fraction, accounting for 20% to 30% of total revenuesSuch shifts in business strategy have arguably stabilized ROE levels within the 6% to 8% range during the last few years, with downward pressures on valuations becoming evident as PB multiples contract.

A retrospective of the securities industry’s valuation trends since 2005 indicates a strong relationship between these metrics and broader market conditions

The precarious state of the market prior to 2010 displayed PB valuations fluctuating between 1.9 and 4 times, which reflected the hardships faced within the industryThe two main bull market phases greatly influenced the sector's valuations, markedly boosting PB from 1.88 times prior to 2005 to a peak of 7.19 times during the 2014-2015 surge.

The association between ROE and valuation becomes increasingly clear through comparative analysis of US investment banksHistorical data from 1975 to 2020 depicts a distinct three-cycle evolution of ROE fluctuationsInitially, the mid-1970s period was characterized by high equity returns that were driven by brokerage models primarily relying on transaction feesHowever, as deregulation took root and commission wars erupted, the industry had to pivot towards heavier asset investment models to sustain profitability, significantly altering the operational landscapes.

Such transitions in the United States mirrored the changes seen in the Chinese brokerage industry, leading to similar resultant dynamics whereby heavy asset-dependent models replaced lighter transaction-based ones, reflecting a broader paradigm shift towards more innovative financial structures that promise continuous growth and stability.

As countries like China seek to build robust brokerage frameworks, a concerted effort on operational innovation becomes essential