With an ROE of 13.97%, CGN Power Co Ltd (SEHK:1816) outpaced its own industry which delivered a less exciting 8.36% over the past year. On the surface, this looks fantastic since we know that 1816 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 1816’s ROE. See our latest analysis for CGN Power
What you must know about ROE
Return on Equity (ROE) is a measure of CGN Power’s profit relative to 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
ROE is measured against cost of equity in order to determine the efficiency of CGN Power’s equity capital deployed. Its cost of equity is 9.68%. Since CGN Power’s return covers its cost in excess of 4.30%, its use of equity capital is efficient and likely to be sustainable. Simply put, CGN Power pays less 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. The other component, asset turnover, illustrates how much revenue CGN Power 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 CGN Power’s historic debt-to-equity ratio. At 232.68%, CGN Power’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
What this means for you:
Are you a shareholder? 1816’s above-industry ROE is encouraging, and is also in excess of its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more 1816 shares. 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%.