The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
China Biologic Products Holdings Inc’s (NASDAQ:CBPO) most recent return on equity was a substandard 6.94% relative to its industry performance of 18.07% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into CBPO’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CBPO’s returns. Let me show you what I mean by this. Check out our latest analysis for China Biologic Products Holdings
What you must know about ROE
Return on Equity (ROE) weighs China Biologic Products Holdings’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. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Biotechnology sector by choosing the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt China Biologic Products Holdings has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
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 China Biologic Products Holdings, which is 10.28%. Given a discrepancy of -3.35% between return and cost, this indicated that China Biologic Products Holdings may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue China Biologic Products Holdings can make from its 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. We can determine if China Biologic Products Holdings’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at China Biologic Products Holdings’s debt-to-equity ratio. Currently, China Biologic Products Holdings has no debt which means its returns are driven purely by equity capital. This could explain why China Biologic Products Holdings’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. China Biologic Products Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For China Biologic Products Holdings, I’ve put together three pertinent factors you should look at:
- 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.
- Valuation: What is China Biologic Products Holdings 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 China Biologic Products Holdings is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Biologic Products Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!