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China Mengniu Dairy Company Limited (SEHK:2319) delivered a less impressive 7.49% ROE over the past year, compared to the 9.18% return generated by its industry. Though 2319’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 2319’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 2319’s returns. Check out our latest analysis for China Mengniu Dairy
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of China Mengniu Dairy’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.07 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. China Mengniu Dairy’s cost of equity is 10.61%. Since China Mengniu Dairy’s return does not cover its cost, with a difference of -3.12%, this means its current use of equity is not efficient and not sustainable. Very simply, China Mengniu Dairy pays more 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue China Mengniu Dairy can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Mengniu Dairy currently has. At 51.59%, China Mengniu Dairy’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China Mengniu Dairy 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 China Mengniu Dairy’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.