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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Zhengzhou Coal Mining Machinery Group Company Limited (HKG:564) generated a below-average return on equity of 3.8% in the past 12 months, while its industry returned 8.7%. Though 564’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 564’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 564’s returns.

Check out our latest analysis for Zhengzhou Coal Mining Machinery Group

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs Zhengzhou Coal Mining Machinery Group’s profit against the level of its shareholders’ equity. An ROE of 3.8% implies HK$0.038 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

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 Zhengzhou Coal Mining Machinery Group, which is 12.3%. Since Zhengzhou Coal Mining Machinery Group’s return does not cover its cost, with a difference of -8.5%, this means its current use of equity is not efficient and not sustainable. Very simply, Zhengzhou Coal Mining Machinery Group pays more 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. The other component, asset turnover, illustrates how much revenue Zhengzhou Coal Mining Machinery Group can make from its 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 Zhengzhou Coal Mining Machinery Group currently has. Currently the debt-to-equity ratio stands at a low 27.1%, which means Zhengzhou Coal Mining Machinery Group still has headroom to take on more leverage in order to increase profits.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Zhengzhou Coal Mining Machinery Group exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Zhengzhou Coal Mining Machinery Group’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Zhengzhou Coal Mining Machinery Group, I’ve put together three relevant factors you should further research:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Valuation: What is Zhengzhou Coal Mining Machinery Group worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Zhengzhou Coal Mining Machinery Group is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Zhengzhou Coal Mining Machinery Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.