Indofood Agri Resources Ltd (SGX:5JS) generated a below-average return on equity of 4.79% in the past 12 months, while its industry returned 10.01%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 5JS’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 5JS’s returns. Let me show you what I mean by this. View our latest analysis for Indofood Agri Resources
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Indofood Agri Resources’s profit relative to its shareholders’ equity. An ROE of 4.79% implies SGD0.05 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 Indofood Agri Resources, which is 10.63%. This means Indofood Agri Resources’s returns actually do not cover its own cost of equity, with a discrepancy of -5.84%. 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 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 Indofood Agri Resources’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Indofood Agri Resources currently has. Currently the debt-to-equity ratio stands at a low 47.21%, which means Indofood Agri Resources still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Indofood Agri Resources’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.