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.
China Yuchai International Limited (NYSE:CYD) delivered an ROE of 12.9% over the past 12 months, which is an impressive feat relative to its industry average of 12.6% during the same period. Superficially, this looks great since we know that CYD has generated big profits with little equity capital; however, ROE doesn’t tell us how much CYD has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether CYD’s ROE is actually sustainable.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs China Yuchai International’s profit against the level of its shareholders’ equity. An ROE of 12.9% implies $0.13 returned on every $1 invested. 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 Yuchai International, which is 11.5%. Given a positive discrepancy of 1.3% between return and cost, this indicates that China Yuchai International pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 reveals how much revenue can be generated from China Yuchai International’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 financial leverage can artificially inflate ROE, we need to look at how much debt China Yuchai International currently has. The debt-to-equity ratio currently stands at a low 14.8%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. China Yuchai International exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For China Yuchai International, I’ve put together three key aspects 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 Yuchai International 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 Yuchai International is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Yuchai International? 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.