This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
CEI Limited (SGX:AVV) outperformed the Electronic Components industry on the basis of its ROE – producing a higher 16.6% relative to the peer average of 8.7% over the past 12 months. On the surface, this looks fantastic since we know that AVV has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of AVV’s ROE.
Check out our latest analysis for CEI
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs CEI’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
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 CEI, which is 8.5%. Since CEI’s return covers its cost in excess of 8.1%, its use of equity capital is efficient and likely to be sustainable. Simply put, CEI pays less for its capital than what it generates 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 CEI’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 CEI’s historic debt-to-equity ratio. At 12.7%, CEI’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.