I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
China Traditional Chinese Medicine Holdings Co Limited’s (HKG:570) most recent return on equity was a substandard 8.8% relative to its industry performance of 14.2% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 570’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 570’s returns.
View our latest analysis for China Traditional Chinese Medicine Holdings
What you must know about ROE
Return on Equity (ROE) is a measure of China Traditional Chinese Medicine Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.088 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
Returns are usually compared to costs to measure the efficiency of capital. China Traditional Chinese Medicine Holdings’s cost of equity is 8.4%. China Traditional Chinese Medicine Holdings’s ROE exceeds its cost by 0.4%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than China Traditional Chinese Medicine Holdings’s case of positive discrepancy. 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 Traditional Chinese Medicine Holdings’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 Traditional Chinese Medicine Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 30.8%, which means China Traditional Chinese Medicine Holdings still has headroom to take on more leverage in order to increase profits.