Can Guangzhou R&F Properties Co Ltd.'s (HKG:2777) ROE Continue To Surpass The Industry Average?

With an ROE of 16.25%, Guangzhou R&F Properties Co Ltd. (SEHK:2777) outpaced its own industry which delivered a less exciting 8.37% over the past year. But what is more interesting is whether 2777 can sustain this above-average ratio. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for Guangzhou R&F Properties

What you must know about ROE

Return on Equity (ROE) weighs Guangzhou R&F Properties’s profit against the level of its shareholders’ equity. An ROE of 16.25% implies HK$0.16 returned on every HK$1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Real Estate Development industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.

Returns are usually compared to costs to measure the efficiency of capital. Guangzhou R&F Properties’s cost of equity is 18.12%. This means Guangzhou R&F Properties’s returns actually do not cover its own cost of equity, with a discrepancy of -1.87%. 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:

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 Guangzhou R&F Properties can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Guangzhou R&F Properties is fuelling ROE by excessively raising debt. Ideally, Guangzhou R&F Properties should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands is significantly high, above 2.5 times, meaning Guangzhou R&F Properties has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Guangzhou R&F Properties exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Guangzhou R&F Properties, I've put together three essential factors 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. Valuation: What is Guangzhou R&F Properties 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 Guangzhou R&F Properties is currently mispriced by the market.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Guangzhou R&F Properties? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!