Why China HGS Real Estate Inc's (NASDAQ:HGSH) ROE Of 4.06% Does Not Tell The Whole Story

China HGS Real Estate Inc (NASDAQ:HGSH) generated a below-average return on equity of 4.06% in the past 12 months, while its industry returned 9.50%. Though HGSH'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 HGSH's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HGSH's returns. Check out our latest analysis for China HGS Real Estate

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

Return on Equity (ROE) is a measure of China HGS Real Estate’s profit relative to its shareholders’ equity. An ROE of 4.06% implies $0.04 returned on every $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 Real Estate Development sector by choosing 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 HGS Real Estate has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

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 China HGS Real Estate, which is 16.60%. Since China HGS Real Estate’s return does not cover its cost, with a difference of -12.54%, this means its current use of equity is not efficient and not sustainable. Very simply, China HGS Real Estate 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:

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from China HGS Real Estate’s 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. We can determine if China HGS Real Estate’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at China HGS Real Estate’s debt-to-equity ratio. Currently the ratio stands at 78.84%, which is reasonable. This means China HGS Real Estate has not taken on too much leverage, and its current ROE is driven by its ability to grow its profit without a huge debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China HGS Real Estate 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 HGS Real Estate’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 HGS Real Estate, I've put together three key factors 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 HGS Real Estate 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 HGS Real Estate is currently mispriced by the market.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China HGS Real Estate? 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.