In This Article:
CITIC Resources Holdings Limited (SEHK:1205) generated a below-average return on equity of 8.12% in the past 12 months, while its industry returned 8.24%. Though 1205’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 1205’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 1205’s returns. See our latest analysis for CITIC Resources Holdings
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. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of CITIC Resources Holdings’s equity capital deployed. Its cost of equity is 15.81%. Since CITIC Resources Holdings’s return does not cover its cost, with a difference of -7.69%, this means its current use of equity is not efficient and not sustainable. Very simply, CITIC Resources Holdings pays more for its capital than what it generates in return. ROE can be broken down into three different 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 CITIC Resources 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 artificially increased through excessive borrowing, we should check CITIC Resources Holdings’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 138.51%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.