The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Frasers Property Limited (SGX:TQ5) delivered an ROE of 6.9% over the past 12 months, which is an impressive feat relative to its industry average of 6.4% during the same period. On the surface, this looks fantastic since we know that TQ5 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable TQ5’s ROE is.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Frasers Property’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Frasers Property’s cost of equity is 15.6%. Since Frasers Property’s return does not cover its cost, with a difference of -8.7%, this means its current use of equity is not efficient and not sustainable. Very simply, Frasers Property 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. The other component, asset turnover, illustrates how much revenue Frasers Property can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Frasers Property’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 104%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Frasers Property’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Although ROE can be a useful metric, it is only a small part of diligent research.