Keppel Infrastructure Trust (SGX:A7RU) delivered a less impressive 0.40% ROE over the past year, compared to the 6.95% return generated by its industry. A7RU’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 A7RU’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of A7RU’s returns. Check out our latest analysis for Keppel Infrastructure Trust

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Keppel Infrastructure Trust’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 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 Keppel Infrastructure Trust, which is 10.04%. This means Keppel Infrastructure Trust’s returns actually do not cover its own cost of equity, with a discrepancy of -9.64%. 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 broken down into three different 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. The other component, asset turnover, illustrates how much revenue Keppel Infrastructure Trust can make from its 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 Keppel Infrastructure Trust currently has. At 167.29%, Keppel Infrastructure Trust’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.