In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
With an ROE of 9.7%, China Datang Corporation Renewable Power Co Limited (HKG:1798) outpaced its own industry which delivered a less exciting 6.6% over the past year. On the surface, this looks fantastic since we know that 1798 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 1798’s ROE.
Check out our latest analysis for China Datang Renewable Power
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs China Datang Renewable Power’s profit against the level of its shareholders’ equity. An ROE of 9.7% implies HK$0.097 returned on every HK$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 China Datang Renewable Power, which is 17.8%. Since China Datang Renewable Power’s return does not cover its cost, with a difference of -8.1%, this means its current use of equity is not efficient and not sustainable. Very simply, China Datang Renewable Power 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:
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 China Datang Renewable Power can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check China Datang Renewable Power’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.