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Shanghai Electric Group Company Limited’s (SEHK:2727) most recent return on equity was a substandard 5.78% relative to its industry performance of 10.95% over the past year. 2727’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 2727’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 2727’s returns. View our latest analysis for Shanghai Electric Group
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 5.78% implies HK$0.06 returned on every HK$1 invested. 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
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 Shanghai Electric Group, which is 8.38%. This means Shanghai Electric Group’s returns actually do not cover its own cost of equity, with a discrepancy of -2.60%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Shanghai Electric Group can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Shanghai Electric Group currently has. At 24.45%, Shanghai Electric Group’s debt-to-equity ratio appears low and indicates that Shanghai Electric Group still has room to increase leverage and grow its profits.