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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
ZTO Express (Cayman) Inc (NYSE:ZTO) generated a below-average return on equity of 13.2% in the past 12 months, while its industry returned 16.4%. 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 ZTO’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ZTO’s returns.
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Breaking down Return on Equity
Return on Equity (ROE) is a measure of ZTO Express (Cayman)’s profit relative to its shareholders’ equity. An ROE of 13.2% implies $0.13 returned on every $1 invested. 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. ZTO Express (Cayman)’s cost of equity is 10.3%. Some of ZTO Express (Cayman)’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for ZTO Express (Cayman) which is reassuring. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from ZTO Express (Cayman)’s 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 ZTO Express (Cayman)’s historic debt-to-equity ratio. Currently, ZTO Express (Cayman) has no debt which means its returns are driven purely by equity capital. This could explain why ZTO Express (Cayman)’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.