This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.

SIIC Environment Holdings Ltd’s (SGX:BHK) most recent return on equity was a substandard 6.45% relative to its industry performance of 12.01% over the past year. BHK’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 BHK’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BHK’s returns.

View our latest analysis for SIIC Environment Holdings

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

Return on Equity (ROE) is a measure of SIIC Environment Holdings’s profit relative to its shareholders’ equity. An ROE of 6.45% implies SGD0.065 returned on every SGD1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of SIIC Environment Holdings’s equity capital deployed. Its cost of equity is 12.91%. Given a discrepancy of -6.45% between return and cost, this indicated that SIIC Environment Holdings may be paying more for its capital than what it’s generating 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 reveals how much revenue can be generated from SIIC Environment Holdings’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. Since financial leverage can artificially inflate ROE, we need to look at how much debt SIIC Environment Holdings currently has. At 109.65%, SIIC Environment Holdings’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.