In This Article:
Zhejiang Expressway Co Ltd. (SEHK:576) delivered an ROE of 14.02% over the past 12 months, which is an impressive feat relative to its industry average of 9.90% during the same period. Superficially, this looks great since we know that 576 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 576 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 576’s ROE is actually sustainable. View our latest analysis for Zhejiang Expressway
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Zhejiang Expressway’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.14 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. Zhejiang Expressway’s cost of equity is 8.38%. Since Zhejiang Expressway’s return covers its cost in excess of 5.64%, its use of equity capital is efficient and likely to be sustainable. Simply put, Zhejiang Expressway pays less 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. The other component, asset turnover, illustrates how much revenue Zhejiang Expressway can make from its 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 Zhejiang Expressway’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 30.57%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Zhejiang Expressway exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.