I am writing today to help inform people who are new to the stock market and want a simplistic look at the return on China XD Plastics Company Limited (NASDAQ:CXDC) stock.
China XD Plastics Company Limited (NASDAQ:CXDC) delivered a less impressive 4.75% ROE over the past year, compared to the 13.93% return generated by its industry. CXDC’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 CXDC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CXDC’s returns. See our latest analysis for China XD Plastics
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of China XD Plastics’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. 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 China XD Plastics’s equity capital deployed. Its cost of equity is 17.05%. Since China XD Plastics’s return does not cover its cost, with a difference of -12.30%, this means its current use of equity is not efficient and not sustainable. Very simply, China XD Plastics 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. The other component, asset turnover, illustrates how much revenue China XD Plastics can make from its 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 inflated by excessive debt, we need to examine China XD Plastics’s debt-to-equity level. At 95.39%, China XD Plastics’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China XD Plastics’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For China XD Plastics, I’ve put together three important aspects you should further research:
- 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.
- Future Earnings: How does China XD Plastics’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China XD Plastics? 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.