This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
SINOPEC Engineering (Group) Co Ltd (HKG:2386) generated a below-average return on equity of 5.4% in the past 12 months, while its industry returned 11.2%. Though 2386’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 2386’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 2386’s returns. Let me show you what I mean by this.
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 5.4% implies HK$0.054 returned on every HK$1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Construction and Engineering sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. SINOPEC Engineering (Group)’s cost of equity is 8.4%. Since SINOPEC Engineering (Group)’s return does not cover its cost, with a difference of -3.0%, this means its current use of equity is not efficient and not sustainable. Very simply, SINOPEC Engineering (Group) 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:
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 SINOPEC Engineering (Group)’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. We can determine if SINOPEC Engineering (Group)’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 SINOPEC Engineering (Group)’s debt-to-equity ratio. The ratio currently stands at a sensible 2.2%, meaning SINOPEC Engineering (Group) has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. SINOPEC Engineering (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 SINOPEC Engineering (Group)’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For SINOPEC Engineering (Group), I’ve put together three fundamental factors you should further research:
- 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 SINOPEC Engineering (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 SINOPEC Engineering (Group) is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SINOPEC Engineering (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 email@example.com.