China Taisan Technology Group Holdings Limited (SGX:AZW) delivered a less impressive 2.20% ROE over the past year, compared to the 9.24% return generated by its industry. Though AZW’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 AZW’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AZW’s returns. Let me show you what I mean by this. Check out our latest analysis for China Taisan Technology Group Holdings
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. China Taisan Technology Group Holdings’s cost of equity is 18.12%. Since China Taisan Technology Group Holdings’s return does not cover its cost, with a difference of -15.92%, this means its current use of equity is not efficient and not sustainable. Very simply, China Taisan Technology Group Holdings 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 reveals how much revenue can be generated from China Taisan Technology Group Holdings’s 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 Taisan Technology Group Holdings’s historic debt-to-equity ratio. At 16.69%, China Taisan Technology Group Holdings’s debt-to-equity ratio appears low and indicates that China Taisan Technology Group Holdings still has room to increase leverage and grow its profits.