Cathay International Holdings Limited (LSE:CTI) generated a below-average return on equity of 3.39% in the past 12 months, while its industry returned 9.01%. 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 CTI’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CTI’s returns. Let me show you what I mean by this. See our latest analysis for CTI
What you must know about ROE
Return on Equity (ROE) weighs CTI’s profit against the level of its shareholders’ equity. For example, if CTI invests £1 in the form of equity, it will generate £0.03 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. CTI’s cost of equity is 17.52%. Since CTI’s return does not cover its cost, with a difference of -14.13%, this means its current use of equity is not efficient and not sustainable. Very simply, CTI 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
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 CTI’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 CTI’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt CTI currently has. The debt-to-equity ratio currently stands at a balanced 119.63%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? CTI’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means CTI still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.