With an ROE of 36.04%, Tianmei Beverage Group Corporation Limited (ASX:TB8) outpaced its own industry which delivered a less exciting 9.21% over the past year. Superficially, this looks great since we know that TB8 has generated big profits with little equity capital; however, ROE doesn’t tell us how much TB8 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable TB8’s ROE is. View our latest analysis for Tianmei Beverage Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Tianmei Beverage Group’s profit relative to its shareholders’ equity. An ROE of 36.04% implies A$0.36 returned on every A$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 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 Tianmei Beverage Group, which is 8.55%. Since Tianmei Beverage Group’s return covers its cost in excess of 27.49%, its use of equity capital is efficient and likely to be sustainable. Simply put, Tianmei Beverage Group pays less 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. Asset turnover reveals how much revenue can be generated from Tianmei Beverage Group’s 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 Tianmei Beverage Group currently has. Currently Tianmei Beverage Group has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
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. Tianmei Beverage Group exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.