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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
With an ROE of 11.4%, Boustead Singapore Limited (SGX:F9D) outpaced its own industry which delivered a less exciting 8.3% over the past year. Superficially, this looks great since we know that F9D has generated big profits with little equity capital; however, ROE doesn’t tell us how much F9D has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether F9D’s ROE is actually sustainable.
View our latest analysis for Boustead Singapore
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.11 in earnings from this. 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 Boustead Singapore’s equity capital deployed. Its cost of equity is 8.5%. Since Boustead Singapore’s return covers its cost in excess of 2.8%, its use of equity capital is efficient and likely to be sustainable. Simply put, Boustead Singapore pays less 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 Boustead Singapore 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 ROE can be inflated by excessive debt, we need to examine Boustead Singapore’s debt-to-equity level. At 15.4%, Boustead Singapore’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.