With an ROE of 12.37%, Tianjin Tianbao Energy Co Ltd. (SEHK:1671) returned in-line to its own industry which delivered 9.89% over the past year. However, whether this ROE is actually impressive depends on if it can be maintained. A measure of sustainable returns is 1671’s financial leverage. If 1671 borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. Check out our latest analysis for Tianjin Tianbao Energy
Breaking down Return on Equity
Return on Equity (ROE) weighs Tianjin Tianbao Energy’s profit against the level of its shareholders’ equity. An ROE of 12.37% implies HK$0.12 returned on every HK$1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Electric Utilities industry may want to choose 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 Tianjin Tianbao Energy 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 Tianjin Tianbao Energy, which is 8.44%. Since Tianjin Tianbao Energy’s return covers its cost in excess of 3.93%, its use of equity capital is efficient and likely to be sustainable. Simply put, Tianjin Tianbao Energy pays less 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Tianjin Tianbao Energy’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Tianjin Tianbao Energy is fuelling ROE by excessively raising debt. Ideally, Tianjin Tianbao Energy should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, Tianjin Tianbao Energy has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Tianjin Tianbao Energy’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Tianjin Tianbao Energy, I’ve compiled three pertinent aspects 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 Tianjin Tianbao Energy 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 Tianjin Tianbao Energy is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Tianjin Tianbao Energy? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!