Semiconductor Manufacturing International Corporation (SEHK:981) generated a below-average return on equity of 3.29% in the past 12 months, while its industry returned 8.36%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 981’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 981’s returns. Check out our latest analysis for Semiconductor Manufacturing International
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Semiconductor Manufacturing International’s profit relative to its shareholders’ equity. An ROE of 3.29% implies HK$0.03 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
Returns are usually compared to costs to measure the efficiency of capital. Semiconductor Manufacturing International’s cost of equity is 11.51%. Since Semiconductor Manufacturing International’s return does not cover its cost, with a difference of -8.22%, this means its current use of equity is not efficient and not sustainable. Very simply, Semiconductor Manufacturing International pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 Semiconductor Manufacturing International 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 inflated by excessive debt, we need to examine Semiconductor Manufacturing International’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 52.64%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? 981’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 981 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.