Xinyuan Real Estate Co Ltd (NYSE:XIN) generated a below-average return on equity of 6.27% in the past 12 months, while its industry returned 7.75%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into XIN’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of XIN’s returns. View our latest analysis for Xinyuan Real Estate
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much XIN can generate in earnings given the amount of equity it has raised. 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 XIN, which is 17.53%. This means XIN’s returns actually do not cover its own cost of equity, with a discrepancy of -11.26%. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue XIN 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 XIN’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check XIN’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a high 248.29%, meaning the below-average ratio is already being driven by a large amount of debt.
What this means for you:
Are you a shareholder? XIN exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more XIN shares. 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 XIN has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Xinyuan Real Estate 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.