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NetEase Inc (NASDAQ:NTES) Delivered A Better ROE Than The Industry, Here’s Why

This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.

NetEase Inc (NASDAQ:NTES) delivered an ROE of 15.3% over the past 12 months, which is an impressive feat relative to its industry average of 11.5% during the same period. On the surface, this looks fantastic since we know that NTES has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether NTES’s ROE is actually sustainable.

View our latest analysis for NetEase

Breaking down Return on Equity

Return on Equity (ROE) weighs NetEase’s profit against the level of its shareholders’ equity. An ROE of 15.3% implies $0.15 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.

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Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. NetEase’s cost of equity is 11.9%. Since NetEase’s return covers its cost in excess of 3.4%, its use of equity capital is efficient and likely to be sustainable. Simply put, NetEase pays less for its capital than what it generates 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

NasdaqGS:NTES Last Perf September 28th 18
NasdaqGS:NTES Last Perf September 28th 18

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from NetEase’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine NetEase’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 28.2%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

NasdaqGS:NTES Historical Debt September 28th 18
NasdaqGS:NTES Historical Debt September 28th 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. NetEase’s above-industry ROE is encouraging, and is also in excess of 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 NetEase, I’ve put together three key factors you should further research:

  1. 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.

  2. Valuation: What is NetEase 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 NetEase is currently mispriced by the market.

  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of NetEase? 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 editorial-team@simplywallst.com.