China New Higher Education Group Limited (SEHK:2001) generated a below-average return on equity of 13.53% in the past 12 months, while its industry returned 13.98%. 2001’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 2001’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 2001’s returns. See our latest analysis for China New Higher Education Group

Breaking down Return on Equity

Return on Equity (ROE) weighs China New Higher Education Group’s profit against the level of 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

ROE is measured against cost of equity in order to determine the efficiency of China New Higher Education Group’s equity capital deployed. Its cost of equity is 14.65%. This means China New Higher Education Group’s returns actually do not cover its own cost of equity, with a discrepancy of -1.12%. 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 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 China New Higher Education Group’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check China New Higher Education Group’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 20.42%, which means China New Higher Education Group still has headroom to take on more leverage in order to increase profits.

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. China New Higher Education Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.