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This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
Metallurgical Corporation of China Ltd (HKG:1618) generated a below-average return on equity of 7.2% in the past 12 months, while its industry returned 11.6%. 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 1618’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 1618’s returns.
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What you must know about ROE
Return on Equity (ROE) is a measure of Metallurgical of China’s profit relative to its shareholders’ equity. An ROE of 7.2% implies HK$0.072 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
Returns are usually compared to costs to measure the efficiency of capital. Metallurgical of China’s cost of equity is 11.5%. Since Metallurgical of China’s return does not cover its cost, with a difference of -4.3%, 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 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Metallurgical of China can generate with its current 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 artificially increased through excessive borrowing, we should check Metallurgical of China’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a balanced 104%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.