Tian Shan Development (Holding) Limited’s (SEHK:2118) most recent return on equity was a substandard 5.98% relative to its industry performance of 8.43% over the past year. 2118’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 2118’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 2118’s returns. Check out our latest analysis for Tian Shan Development (Holding)

What you must know about ROE

Return on Equity (ROE) weighs Tian Shan Development (Holding)’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Tian Shan Development (Holding), which is 18.12%. Given a discrepancy of -12.14% between return and cost, this indicated that Tian Shan Development (Holding) may be paying more for its capital than what it’s generating 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

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 Tian Shan Development (Holding)’s 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 inflated by excessive debt, we need to examine Tian Shan Development (Holding)’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its below-average ROE is already being driven by significant debt levels.