Shine Corporate Limited’s (ASX:SHJ) most recent return on equity was a substandard 10.22% relative to its industry performance of 12.07% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into SHJ's past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SHJ's returns. Let me show you what I mean by this. View our latest analysis for Shine

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

Return on Equity (ROE) is a measure of SHJ’s profit relative to its shareholders’ equity. It essentially shows how much SHJ 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 SHJ, which is 9.98%. While SHJ’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for SHJ which is encouraging. 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 SHJ is with its cost management. The other component, asset turnover, illustrates how much revenue SHJ can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt SHJ currently has. Currently the debt-to-equity ratio stands at a low 25.45%, which means SHJ still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? Although SHJ’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity, which is encouraging. Since ROE is not inflated by excessive debt, it might be a good time to add more of SHJ to your portfolio if your personal research is confirming what the ROE is telling you. If you're looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.