With an ROE of 16.97%, Captii Limited (SGX:AWV) outpaced its own industry which delivered a less exciting 12.06% over the past year. On the surface, this looks fantastic since we know that AWV has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether AWV’s ROE is actually sustainable. Check out our latest analysis for Captii

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. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.17 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 Captii’s equity capital deployed. Its cost of equity is 10.30%. This means Captii returns enough to cover its own cost of equity, with a buffer of 6.67%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Captii 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 Captii currently has. Currently, Captii has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.

What this means for you:

Are you a shareholder? AWV exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of AWV 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%.