Aluminum Corporation Of China Limited (SEHK:2600) delivered a less impressive 5.73% ROE over the past year, compared to the 8.54% return generated by its industry. 2600’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 2600’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 2600’s returns. Check out our latest analysis for Aluminum Of China
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Aluminum Of China’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Aluminum Of China’s cost of equity is 14.31%. Since Aluminum Of China’s return does not cover its cost, with a difference of -8.58%, this means its current use of equity is not efficient and not sustainable. Very simply, Aluminum Of China pays more 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Aluminum Of China 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. Since ROE can be artificially increased through excessive borrowing, we should check Aluminum Of China’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a high 202.92%, which means its below-average ROE is already being driven by significant debt levels.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Aluminum Of China’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Aluminum Of China’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Aluminum Of China, there are three key factors you should further examine:
- 1. 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.
- 2. Valuation: What is Aluminum Of China 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 Aluminum Of China is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Aluminum Of China? 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 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.