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Tantech Holdings Ltd (NASDAQ:TANH) generated a below-average return on equity of 2.58% in the past 12 months, while its industry returned 13.48%. TANH’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 TANH’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of TANH’s returns. See our latest analysis for Tantech Holdings
What you must know about ROE
Return on Equity (ROE) is a measure of Tantech Holdings’s profit relative to its shareholders’ equity. An ROE of 2.58% implies $0.03 returned on every $1 invested. 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 Tantech Holdings, which is 8.89%. Given a discrepancy of -6.31% between return and cost, this indicated that Tantech Holdings may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Tantech Holdings can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Tantech Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 10.33%, meaning Tantech Holdings still has headroom to borrow debt to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Tantech Holdings exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Tantech Holdings’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.