This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Xinyuan Real Estate Co Ltd (NYSE:XIN) performed in line with its real estate development industry on the basis of its ROE – producing a return of 8.51% relative to the peer average of 10.85% over the past 12 months. But what is more interesting is whether XIN can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of XIN’s returns.
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.085 in earnings from this. Investors seeking to maximise their return in the Real Estate Development 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
ROE is measured against cost of equity in order to determine the efficiency of Xinyuan Real Estate’s equity capital deployed. Its cost of equity is 17.05%. This means Xinyuan Real Estate’s returns actually do not cover its own cost of equity, with a discrepancy of -8.54%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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 shows how much revenue Xinyuan Real Estate can generate with its current 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 assess whether Xinyuan Real Estate is fuelling ROE by excessively raising debt. Ideally, Xinyuan Real Estate should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands is significantly high, above 2.5 times, meaning Xinyuan Real Estate has taken on a disproportionately large level of debt which is driving its return. The company’s ability to produce profit growth hinges on its large debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Xinyuan Real Estate 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Xinyuan Real Estate, I’ve put together three essential 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Xinyuan Real Estate’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 Xinyuan Real Estate? 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.