Did Huaneng Renewables Corporation Limited (HKG:958) Create Value For Shareholders?
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 12.4%, Huaneng Renewables Corporation Limited (HKG:958) outpaced its own industry which delivered a less exciting 6.6% over the past year. Superficially, this looks great since we know that 958 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 958 has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether 958’s ROE is actually sustainable.
See our latest analysis for Huaneng Renewables
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Huaneng Renewables’s profit relative to its shareholders’ equity. An ROE of 12.4% implies HK$0.12 returned on every HK$1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Huaneng Renewables’s equity capital deployed. Its cost of equity is 10.0%. Since Huaneng Renewables’s return covers its cost in excess of 2.3%, its use of equity capital is efficient and likely to be sustainable. Simply put, Huaneng Renewables pays less 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:
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. Asset turnover reveals how much revenue can be generated from Huaneng Renewables’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Huaneng Renewables’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 191%, meaning the above-average ratio is a result of a large amount of debt.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Huaneng Renewables’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Huaneng Renewables, I’ve put together three fundamental factors 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.
Valuation: What is Huaneng Renewables 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 Huaneng Renewables is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Huaneng Renewables? 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 editorial-team@simplywallst.com.
