The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
BOC Aviation Limited (HKG:2588) outperformed the Trading Companies and Distributors industry on the basis of its ROE – producing a higher 16.1% relative to the peer average of 10.2% over the past 12 months. Superficially, this looks great since we know that 2588 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 2588 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 2588’s ROE.
Check out our latest analysis for BOC Aviation
Breaking down Return on Equity
Return on Equity (ROE) is a measure of BOC Aviation’s profit relative to its shareholders’ equity. An ROE of 16.1% implies HK$0.16 returned on every HK$1 invested. 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 measured against cost of equity in order to determine the efficiency of BOC Aviation’s equity capital deployed. Its cost of equity is 17.8%. This means BOC Aviation’s returns actually do not cover its own cost of equity, with a discrepancy of -1.7%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue BOC Aviation can generate with its current 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 BOC Aviation’s historic debt-to-equity ratio. At over 2.5 times, BOC Aviation’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. BOC Aviation’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of BOC Aviation’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.