Bukit Sembawang Estates Limited’s (SGX:B61) most recent return on equity was a substandard 2.95% relative to its industry performance of 6.97% over the past year. B61’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 B61’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of B61’s returns. View our latest analysis for Bukit Sembawang Estates

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Bukit Sembawang Estates’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.03 in earnings from this. 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

Returns are usually compared to costs to measure the efficiency of capital. Bukit Sembawang Estates’s cost of equity is 8.38%. Given a discrepancy of -5.43% between return and cost, this indicated that Bukit Sembawang Estates may be paying more for its capital than what it’s generating 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Bukit Sembawang Estates can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Bukit Sembawang Estates currently has. Currently, Bukit Sembawang Estates has no debt which means its returns are driven purely by equity capital. This could explain why Bukit Sembawang Estates’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.