I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
China Construction Bank Corporation (HKG:939) outperformed the Diversified Banks industry on the basis of its ROE – producing a higher 13.4% relative to the peer average of 11.8% over the past 12 months. Superficially, this looks great since we know that 939 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 939 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 939’s ROE.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs China Construction Bank’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.13 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 Construction Bank, which is 10.5%. Since China Construction Bank’s return covers its cost in excess of 2.8%, its use of equity capital is efficient and likely to be sustainable. Simply put, China Construction Bank pays less 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
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 China Construction Bank can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Construction Bank currently has. The debt-to-equity ratio currently stands at a balanced 98.8%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China Construction Bank exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For China Construction Bank, there are three key factors you should further examine:
- 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 China Construction Bank 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 Construction Bank is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Construction Bank? 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.