I am writing today to help inform people who are new to the stock market and want to begin learning the link between China Chengtong Development Group Limited (HKG:217)’s return fundamentals and stock market performance.
China Chengtong Development Group Limited’s (HKG:217) most recent return on equity was a substandard 0.79% relative to its industry performance of 7.97% over the past year. 217’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 217’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 217’s returns. View out our latest analysis for China Chengtong Development Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of China Chengtong Development Group’s profit relative to its shareholders’ equity. An ROE of 0.79% implies HK$0.0079 returned on every HK$1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Trading Companies and Distributors sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of China Chengtong Development Group’s equity capital deployed. Its cost of equity is 9.66%. Since China Chengtong Development Group’s return does not cover its cost, with a difference of -8.87%, this means its current use of equity is not efficient and not sustainable. Very simply, China Chengtong Development Group 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
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 China Chengtong Development Group can generate with its current 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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at China Chengtong Development Group’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 7.20%, meaning China Chengtong Development Group has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China Chengtong Development Group’s ROE is underwhelming relative to the industry average, and its returns were also not strong 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 Chengtong Development Group, I’ve put together three pertinent factors you should further examine:
- 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.
- Valuation: What is China Chengtong Development Group 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 Chengtong Development Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Chengtong Development Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!