This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

China New Town Development Company Limited’s (HKG:1278) most recent return on equity was a substandard 5.53% relative to its industry performance of 9.40% over the past year. Though 1278’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 1278’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of 1278’s returns.

View our latest analysis for China New Town Development

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 5.53% implies HK$0.055 returned on every HK$1 invested. 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 measured against cost of equity in order to determine the efficiency of China New Town Development’s equity capital deployed. Its cost of equity is 12.01%. Since China New Town Development’s return does not cover its cost, with a difference of -6.48%, this means its current use of equity is not efficient and not sustainable. Very simply, China New Town Development pays more for its capital than what it generates in return. ROE can be split up into three useful 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 New Town Development 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. Since ROE can be inflated by excessive debt, we need to examine China New Town Development’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 46.32%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China New Town Development’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of China New Town Development’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 New Town Development, I’ve compiled three important 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 China New Town Development 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 New Town Development is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of China New Town Development? 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 past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.