Public joint-stock company Chelyabinsk Energy Retail Company (MISX:CLSB) outperformed the Electric Utilities industry on the basis of its ROE – producing a higher 17.21% relative to the peer average of 9.31% over the past 12 months. On the surface, this looks fantastic since we know that CLSB has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CLSB’s ROE is. Check out our latest analysis for Chelyabinsk Energy Retail
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Chelyabinsk Energy Retail’s profit relative to its shareholders’ equity. For example, if the company invests RUB1 in the form of equity, it will generate RUB0.17 in earnings from this. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Chelyabinsk Energy Retail, which is 22.95%. Given a discrepancy of -5.74% between return and cost, this indicated that Chelyabinsk Energy Retail may be paying more for its capital than what it’s generating 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. The other component, asset turnover, illustrates how much revenue Chelyabinsk Energy Retail can make from its 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 inflated by excessive debt, we need to examine Chelyabinsk Energy Retail’s debt-to-equity level. At over 2.5 times, Chelyabinsk Energy Retail’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Chelyabinsk Energy Retail exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of Chelyabinsk Energy Retail’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.