In This Article:
Metallurgical Corporation of China Ltd (SEHK:1618) delivered a less impressive 6.50% ROE over the past year, compared to the 14.77% return generated by its industry. 1618’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on 1618’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 1618’s returns. See our latest analysis for Metallurgical of China
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Metallurgical of China’s profit relative to its shareholders’ equity. An ROE of 6.50% implies HK$0.06 returned on every HK$1 invested. 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 measured against cost of equity in order to determine the efficiency of Metallurgical of China’s equity capital deployed. Its cost of equity is 9.05%. Since Metallurgical of China’s return does not cover its cost, with a difference of -2.55%, this means its current use of equity is not efficient and not sustainable. Very simply, Metallurgical of China pays more for its capital than what it generates 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Metallurgical of China can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Metallurgical of China’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 106.31%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
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. Metallurgical of China exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Metallurgical of China’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.