Hupsteel Limited (SGX:BMH) generated a below-average return on equity of 1.83% in the past 12 months, while its industry returned 2.54%. Though BMH’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on BMH’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BMH’s returns. View our latest analysis for Hupsteel

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Hupsteel’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.02 in earnings from this. 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

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 Hupsteel, which is 8.38%. This means Hupsteel’s returns actually do not cover its own cost of equity, with a discrepancy of -6.55%. 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Hupsteel can generate with its current 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 Hupsteel currently has. Currently Hupsteel has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Hupsteel’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.