In This Article:
Beijing Gas Blue Sky Holdings Limited (SGX:UQ7) delivered a less impressive 1.74% ROE over the past year, compared to the 11.75% return generated by its industry. UQ7’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on UQ7’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of UQ7’s returns. Let me show you what I mean by this. See our latest analysis for Beijing Gas Blue Sky Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Beijing Gas Blue Sky Holdings’s profit relative to its shareholders’ equity. It essentially shows how much the company 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 Beijing Gas Blue Sky Holdings, which is 8.53%. Since Beijing Gas Blue Sky Holdings’s return does not cover its cost, with a difference of -6.79%, this means its current use of equity is not efficient and not sustainable. Very simply, Beijing Gas Blue Sky Holdings pays more 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
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 Beijing Gas Blue Sky Holdings’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 Beijing Gas Blue Sky Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 31.96%, which means Beijing Gas Blue Sky Holdings still has headroom to take on more leverage in order to increase profits.