China Aerospace International Holdings Limited (SEHK:31) delivered a less impressive 5.85% ROE over the past year, compared to the 13.74% return generated by its industry. Though 31’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 31’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 31’s returns. View our latest analysis for China Aerospace International Holdings
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much 31 can generate in earnings given the amount of equity it has raised. 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. 31’s cost of equity is 12.14%. Given a discrepancy of -6.29% between return and cost, this indicated that 31 may be paying more for its capital than what it’s generating 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient 31 is with its cost management. Asset turnover reveals how much revenue can be generated from 31’s 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 31’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 14.57%, meaning 31 still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? 31’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means 31 still has room to improve shareholder returns by raising debt to fund new investments. 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%.