Dongfeng Motor Group Company Limited’s (SEHK:489) most recent return on equity was a substandard 14.24% relative to its industry performance of 14.25% over the past year. 489’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 489’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 489’s returns. See our latest analysis for Dongfeng Motor Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Dongfeng Motor Group’s profit relative to its shareholders’ equity. An ROE of 14.24% implies HK$0.14 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. Dongfeng Motor Group’s cost of equity is 8.53%. While Dongfeng Motor Group’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Dongfeng Motor Group which is encouraging. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Dongfeng Motor Group can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Dongfeng Motor Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 12.59%, which means Dongfeng Motor Group still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? Even though 489 returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 489 to your portfolio if your personal research is confirming what the ROE is telling you. 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%.