China Yuchai International Limited (NYSE:CYD) generated a below-average return on equity of 9.71% in the past 12 months, while its industry returned 11.66%. 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 CYD’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CYD’s returns. View our latest analysis for China Yuchai International
What you must know about ROE
Return on Equity (ROE) weighs CYD’s profit against the level of its shareholders’ equity. An ROE of 9.71% implies $0.1 returned on every $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 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 CYD, which is 9.62%. Some of CYD’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for CYD which is reassuring. ROE can be broken down into three different 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 CYD’s 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 CYD’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CYD’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 9.12%, which means CYD still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? While CYD exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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 CYD 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 China Yuchai International 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.