I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
China Advanced Construction Materials Group Inc’s (NASDAQ:CADC) most recent return on equity was a substandard 4.68% relative to its industry performance of 9.73% over the past year. CADC’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 CADC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CADC’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of China Advanced Construction Materials Group’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.047 in earnings from this. Investors seeking to maximise their return in the Construction Materials 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 China Advanced Construction Materials Group 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 Advanced Construction Materials Group, which is 11.56%. Given a discrepancy of -6.88% between return and cost, this indicated that China Advanced Construction Materials Group may be paying more for its capital than what it’s generating 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 Advanced Construction Materials Group can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 Advanced Construction Materials Group’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 228.14%, which is relatively high. This means China Advanced Construction Materials Group’s below-average ROE is already being driven by its high leverage and its ability to grow profit hinges on a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. China Advanced Construction Materials Group exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For China Advanced Construction Materials Group, there are three fundamental aspects 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for China Advanced Construction Materials Group’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Advanced Construction Materials 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 firstname.lastname@example.org.