With a ROE of 10.8%, Gulf Resources Inc (NASDAQ:GURE) could hardly match the performance of its industry, which averaged a ROE of 22.96%. However, a multitude of factors affect the ROE, which is unequivocally the most popular profitability ratio, and digging through them in detail is a must before arriving at any conclusion. View our latest analysis for Gulf Resources
Breaking down ROE — the mother of all ratios
ROE is simply the percentage of past year earnings against the book value of shareholders’ equity, which is the sum of retained earnings and capital raised through equity offerings. While an ROE ratio of more than 15% would draw any investor’s attention, historically, established companies in the developed countries have delivered an ROE between 10% and 12%.
Return on Equity = Net Profit ÷ Shareholders Equity
No matter how high or low return a company generates on equity, it should be more than the cost of equity for value creation. For GURE, the cost of equity estimate comes at 8.35% based on the Capital Asset Pricing Model using the current risk free rate and a levered beta to account for financial leverage. That compares to Gulf Resources’s 10.8% ROE.
ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A reflection of how net profit margin has affected ROE in the past can be seen in the trend of income and revenue. An investor can gauge a fair estimate of how it’s going to play out in the future by looking at the analysts’ forecasts in the years ahead. The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. Gulf Resources’s ROA stood at 8.4% in the past year, compared to the industry’s 6.43%.
We can assess whether GURE is fuelling ROE by excessively raising debt or it has a balanced capital structure by looking at the historic debt-equity trend of the company. While Gulf Resources’s debt to equity ratio currently stands at 0.01, investors should assess how it has changed over the past few years. To account for leverage, we should look at GURE’s Return on capital, which stood at 14% in the past year versus industry’s -1.22%. ROC is earnings as a percentage of overall employed capital compared to just equity as in the case of ROE.
ROE – It’s not just another ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency both through the income statement and the balance sheet, along with telling you how just changing the capital structure of the company can impact perceived return. What are the analysts thinking about Gulf Resources’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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