Fuling Global Inc’s (NASDAQ:FORK) most recent return on equity was a substandard 10.85% relative to its industry performance of 12.81% over the past year. 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 FORK’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FORK’s returns. Check out our latest analysis for Fuling Global
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Fuling Global’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 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 Fuling Global, which is 11.89%. Since Fuling Global’s return does not cover its cost, with a difference of -1.04%, this means its current use of equity is not efficient and not sustainable. Very simply, Fuling Global 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:
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 Fuling Global can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Fuling Global’s historic debt-to-equity ratio. At 70.11%, Fuling Global’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Fuling Global exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Fuling Global, I’ve put together three fundamental aspects you should look at:
- 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 Fuling Global’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 Fuling Global? 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.