China Fire Safety Enterprise Group Limited (SEHK:445) delivered a less impressive 1.60% ROE over the past year, compared to the 7.05% return generated by its industry. 445’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 445’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 445’s returns. See our latest analysis for China Fire Safety Enterprise Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs China Fire Safety Enterprise Group’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 seeking to maximise their return in the Construction Machinery and Heavy Trucks industry may want to choose 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. China Fire Safety Enterprise Group’s cost of equity is 10.86%. Since China Fire Safety Enterprise Group’s return does not cover its cost, with a difference of -9.26%, this means its current use of equity is not efficient and not sustainable. Very simply, China Fire Safety Enterprise 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:
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 China Fire Safety Enterprise Group can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at China Fire Safety Enterprise Group’s debt-to-equity ratio to examine sustainability of its returns. Currently, China Fire Safety Enterprise Group has no debt which means its returns are driven purely by equity capital. This could explain why China Fire Safety Enterprise Group’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China Fire Safety Enterprise Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of China Fire Safety Enterprise 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 China Fire Safety Enterprise Group, I’ve put together three pertinent aspects 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 China Fire Safety Enterprise 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 China Fire Safety Enterprise Group is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Fire Safety Enterprise 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!