CapitaLand Limited (SGX:C31) delivered an ROE of 8.51% over the past 12 months, which is an impressive feat relative to its industry average of 7.37% during the same period. While the impressive ratio tells us that C31 has made significant profits from little equity capital, ROE doesn’t tell us if C31 has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of C31’s ROE. View our latest analysis for CapitaLand

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 8.51% implies SGD0.09 returned on every SGD1 invested. 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 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 CapitaLand, which is 11.24%. This means CapitaLand’s returns actually do not cover its own cost of equity, with a discrepancy of -2.72%. 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 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. Asset turnover reveals how much revenue can be generated from CapitaLand’s 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 CapitaLand’s debt-to-equity level. At 62.43%, CapitaLand’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

What this means for you:

Are you a shareholder? C31’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as C31 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.