China Dairy Corporation Limited (ASX:CDC) delivered an ROE of 17.22% over the past 12 months, which is an impressive feat relative to its industry average of 10.38% during the same period. While the impressive ratio tells us that CDC has made significant profits from little equity capital, ROE doesn’t tell us if CDC has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CDC’s ROE is. See our latest analysis for China Dairy
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 China Dairy, which is 8.55%. This means China Dairy returns enough to cover its own cost of equity, with a buffer of 8.67%. This sustainable practice implies that the company pays less 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
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 China Dairy’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 inflated by excessive debt, we need to examine China Dairy’s debt-to-equity level. At 1.33%, China Dairy’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.