I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
CT Environmental Group Limited (HKG:1363) delivered an ROE of 13.3% over the past 12 months, which is an impressive feat relative to its industry average of 9.9% during the same period. Superficially, this looks great since we know that 1363 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 1363 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 1363’s ROE is.
View our latest analysis for CT Environmental Group
What you must know about ROE
Return on Equity (ROE) weighs CT Environmental Group’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 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 CT Environmental Group, which is 8.4%. Given a positive discrepancy of 4.9% between return and cost, this indicates that CT Environmental Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful 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 CT Environmental Group’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt CT Environmental Group currently has. The debt-to-equity ratio currently stands at a sensible 76.0%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. CT Environmental Group’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.