Zhengzhou Coal Mining Machinery Group Company Limited (SEHK:564) generated a below-average return on equity of 2.58% in the past 12 months, while its industry returned 10.00%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 564’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 564’s returns. Let me show you what I mean by this. Check out our latest analysis for Zhengzhou Coal Mining Machinery Group
What you must know about ROE
Return on Equity (ROE) weighs Zhengzhou Coal Mining Machinery Group’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.03 in earnings from this. 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 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 Zhengzhou Coal Mining Machinery Group, which is 11.79%. Given a discrepancy of -9.21% between return and cost, this indicated that Zhengzhou Coal Mining Machinery Group may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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. Asset turnover reveals how much revenue can be generated from Zhengzhou Coal Mining Machinery Group’s 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 Zhengzhou Coal Mining Machinery Group’s historic debt-to-equity ratio. At 9.11%, Zhengzhou Coal Mining Machinery Group’s debt-to-equity ratio appears low and indicates that Zhengzhou Coal Mining Machinery Group still has room to increase leverage and grow its profits.