This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Jiangxi Bank Co Ltd (HKG:1916) delivered a less impressive 11.0% ROE over the past year, compared to the 11.8% return generated by its industry. 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 1916’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 1916’s returns.
View our latest analysis for Jiangxi Bank
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Jiangxi Bank’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.11 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. Jiangxi Bank’s cost of equity is 10.5%. Jiangxi Bank’s ROE exceeds its cost by 0.5%, 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 Jiangxi Bank’s case of positive discrepancy. ROE can be dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue Jiangxi Bank can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Jiangxi Bank currently has. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. While Jiangxi Bank exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. However, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.