Why China Reinsurance (Group) Corporation (HKG:1508) Delivered An Inferior ROE Compared To The Industry
China Reinsurance (Group) Corporation (SEHK:1508) generated a below-average return on equity of 7.64% in the past 12 months, while its industry returned 10.43%. 1508’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 1508’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 1508’s returns. See our latest analysis for China Reinsurance (Group)
Breaking down Return on Equity
Return on Equity (ROE) is a measure of China Reinsurance (Group)’s profit relative to its shareholders’ equity. An ROE of 7.64% implies HK$0.08 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
Returns are usually compared to costs to measure the efficiency of capital. China Reinsurance (Group)’s cost of equity is 9.49%. Given a discrepancy of -1.85% between return and cost, this indicated that China Reinsurance (Group) 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:
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 shows how much revenue China Reinsurance (Group) 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 financial leverage can artificially inflate ROE, we need to look at how much debt China Reinsurance (Group) currently has. At 18.82%, China Reinsurance (Group)’s debt-to-equity ratio appears low and indicates that China Reinsurance (Group) still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? 1508 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as 1508 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 1508, 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 Reinsurance (Group) 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.
