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Orient Paper Inc’s (AMEX:ONP) most recent return on equity was a substandard 3.53% relative to its industry performance of 10.74% over the past year. Though ONP’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 ONP’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ONP’s returns. See our latest analysis for Orient Paper
What you must know about ROE
Return on Equity (ROE) weighs Orient Paper’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. 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. Orient Paper’s cost of equity is 14.84%. This means Orient Paper’s returns actually do not cover its own cost of equity, with a discrepancy of -11.31%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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. The other component, asset turnover, illustrates how much revenue Orient Paper 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 artificially increased through excessive borrowing, we should check Orient Paper’s historic debt-to-equity ratio. At 15.36%, Orient Paper’s debt-to-equity ratio appears low and indicates that Orient Paper still has room to increase leverage and grow its profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Orient Paper exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.