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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 13.37%, Jinchuan Group International Resources Co Ltd (HKG:2362) outpaced its own industry which delivered a less exciting 9.97% over the past year. On the surface, this looks fantastic since we know that 2362 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 2362’s ROE is actually sustainable.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Jinchuan Group International Resources’s profit relative to 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
ROE is measured against cost of equity in order to determine the efficiency of Jinchuan Group International Resources’s equity capital deployed. Its cost of equity is 8.44%. Given a positive discrepancy of 4.93% between return and cost, this indicates that Jinchuan Group International Resources pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Jinchuan Group International Resources’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 Jinchuan Group International Resources’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 49.04%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.