With an ROE of 7.75%, CITIC Envirotech Ltd (SGX:CEE) outpaced its own industry which delivered a less exciting 7.26% over the past year. Superficially, this looks great since we know that CEE has generated big profits with little equity capital; however, ROE doesn’t tell us how much CEE has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CEE’s ROE is. See our latest analysis for CITIC Envirotech
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of CITIC Envirotech’s profit relative to its shareholders’ equity. An ROE of 7.75% implies SGD0.08 returned on every SGD1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. CITIC Envirotech’s cost of equity is 8.38%. This means CITIC Envirotech’s returns actually do not cover its own cost of equity, with a discrepancy of -0.62%. 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 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
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 CITIC Envirotech’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 CITIC Envirotech’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 39.36%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. CITIC Envirotech’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.