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China Power International Development Limited (SEHK:2380) delivered a less impressive 3.44% ROE over the past year, compared to the 6.87% return generated by its industry. 2380’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 2380’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 2380’s returns. See our latest analysis for China Power International Development
What you must know about ROE
Return on Equity (ROE) is a measure of China Power International Development’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.03 in earnings from this. 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. China Power International Development’s cost of equity is 12.17%. Since China Power International Development’s return does not cover its cost, with a difference of -8.73%, this means its current use of equity is not efficient and not sustainable. Very simply, China Power International Development pays more for its capital than what it generates in return. ROE can be broken down into three different 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 reveals how much revenue can be generated from China Power International Development’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Power International Development currently has. At 139.15%, China Power International Development’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.