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What You Must Know About China Foods Limited’s (HKG:506) 8.7% ROE

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 Foods Limited (HKG:506) delivered a less impressive 8.7% ROE over the past year, compared to the 9.4% return generated by its industry. Though 506’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on 506’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 506’s returns.

Check out our latest analysis for China Foods

Peeling the layers of ROE – trisecting a company’s profitability

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 8.7% implies HK$0.087 returned on every HK$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 measured against cost of equity in order to determine the efficiency of China Foods’s equity capital deployed. Its cost of equity is 10.1%. Since China Foods’s return does not cover its cost, with a difference of -1.4%, this means its current use of equity is not efficient and not sustainable. Very simply, China Foods pays more for its capital than what it generates in return. ROE can be broken down into three different 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

SEHK:506 Last Perf October 1st 18
SEHK:506 Last Perf October 1st 18

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue China Foods can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Foods currently has. The debt-to-equity ratio currently stands at a low 27.5%, meaning China Foods still has headroom to borrow debt to increase profits.

SEHK:506 Historical Debt October 1st 18
SEHK:506 Historical Debt October 1st 18

Next Steps:

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 Foods exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of China Foods’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For China Foods, there are three key aspects 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 China Foods 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 Foods is currently mispriced by the market.

  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Foods? 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.

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