What You Must Know About China Fordoo Holdings Limited's (HKG:2399) Return on Equity

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 begin learning the link between China Fordoo Holdings Limited (HKG:2399)’s return fundamentals and stock market performance.

China Fordoo Holdings Limited (HKG:2399) delivered a less impressive 1.52% ROE over the past year, compared to the 9.88% return generated by its industry. 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 2399's past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 2399's returns. View out our latest analysis for China Fordoo Holdings

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 1.52% implies HK$0.015 returned on every HK$1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Apparel, Accessories and Luxury Goods sector by investing in the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt China Fordoo Holdings has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of China Fordoo Holdings’s equity capital deployed. Its cost of equity is 8.44%. This means China Fordoo Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -6.92%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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. The other component, asset turnover, illustrates how much revenue China Fordoo Holdings can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether China Fordoo Holdings is fuelling ROE by excessively raising debt. Ideally, China Fordoo Holdings should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 33.26%, which is sensible and indicates China Fordoo Holdings has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and China Fordoo Holdings still has room to increase leverage and grow future returns.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. China Fordoo Holdings 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 China Fordoo Holdings, I've compiled three relevant aspects you should look at:

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. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for China Fordoo Holdings's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China Fordoo Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.