In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
CGN Power Co Ltd (HKG:1816) delivered an ROE of 10.6% over the past 12 months, which is an impressive feat relative to its industry average of 6.6% during the same period. On the surface, this looks fantastic since we know that 1816 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 1816’s ROE.
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What you must know about ROE
Return on Equity (ROE) is a measure of CGN Power’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
Returns are usually compared to costs to measure the efficiency of capital. CGN Power’s cost of equity is 11.4%. Since CGN Power’s return does not cover its cost, with a difference of -0.8%, this means its current use of equity is not efficient and not sustainable. Very simply, CGN Power 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
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 CGN Power 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 CGN Power’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 205%, meaning the above-average ratio is a result of 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. CGN Power 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 CGN Power’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.