In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 11.5%, China Suntien Green Energy Corporation Limited (HKG:956) outpaced its own industry which delivered a less exciting 10.6% over the past year. On the surface, this looks fantastic since we know that 956 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 956’s ROE is.
Check out our latest analysis for China Suntien Green Energy
What you must know about ROE
Return on Equity (ROE) is a measure of China Suntien Green Energy’s profit relative to its shareholders’ equity. An ROE of 11.5% implies HK$0.12 returned on every HK$1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of China Suntien Green Energy’s equity capital deployed. Its cost of equity is 17.8%. Since China Suntien Green Energy’s return does not cover its cost, with a difference of -6.3%, this means its current use of equity is not efficient and not sustainable. Very simply, China Suntien Green Energy 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue China Suntien Green Energy can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check China Suntien Green Energy’s historic debt-to-equity ratio. At 176%, China Suntien Green Energy’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. China Suntien Green Energy’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of China Suntien Green Energy’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.