China Techfaith Wireless Communication Technology Limited’s (NASDAQ:CNTF) most recent return on equity was a substandard 1.24% relative to its industry performance of 7.19% over the past year. CNTF'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 CNTF’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CNTF's returns. Check out our latest analysis for China Techfaith Wireless Communication Technology
What you must know about ROE
Return on Equity (ROE) weighs CNTF’s profit against the level of its shareholders’ equity. For example, if CNTF invests $1 in the form of equity, it will generate $0.01 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 measured against cost of equity in order to determine the efficiency of CNTF’s equity capital deployed. Its cost of equity is 10.88%. Given a discrepancy of -9.63% between return and cost, this indicated that CNTF 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
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 CNTF’s 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 CNTF’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check CNTF’s historic debt-to-equity ratio. At 5.84%, CNTF’s debt-to-equity ratio appears low and indicates that CNTF still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? CNTF’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means CNTF still has room to improve shareholder returns by raising debt to fund new investments. If you're looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in CNTF, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on China Techfaith Wireless Communication Technology to help you make a more informed investment decision.
To help readers see pass 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.