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This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
China Nuclear Energy Technology Corporation Limited (HKG:611) delivered an ROE of 13.8% over the past 12 months, which is an impressive feat relative to its industry average of 11.9% during the same period. On the surface, this looks fantastic since we know that 611 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 611’s ROE.
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Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs China Nuclear Energy Technology’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
Returns are usually compared to costs to measure the efficiency of capital. China Nuclear Energy Technology’s cost of equity is 12.4%. This means China Nuclear Energy Technology returns enough to cover its own cost of equity, with a buffer of 1.4%. This sustainable practice implies that the company 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 China Nuclear Energy Technology’s 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 China Nuclear Energy Technology’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a high 216%, meaning the above-average ratio is a result of a large amount of debt.