Lum Chang Holdings Limited (SGX:L19) outperformed the Construction and Engineering industry on the basis of its ROE – producing a higher 9.26% relative to the peer average of 8.24% over the past 12 months. On the surface, this looks fantastic since we know that L19 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of L19’s ROE. Check out our latest analysis for Lum Chang Holdings

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

Return on Equity (ROE) weighs Lum Chang Holdings’s profit against the level of its shareholders’ equity. An ROE of 9.26% implies SGD0.09 returned on every SGD1 invested. 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 measured against cost of equity in order to determine the efficiency of Lum Chang Holdings’s equity capital deployed. Its cost of equity is 12.10%. This means Lum Chang Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -2.83%. 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 broken down into three different 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 shows how much revenue Lum Chang Holdings can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Lum Chang Holdings currently has. Currently the debt-to-equity ratio stands at a reasonable 78.85%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Lum Chang Holdings’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.

For Lum Chang Holdings, I’ve compiled three key aspects you should further research:

• 1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

• 2. Future Earnings: How does Lum Chang Holdings’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Lum Chang Holdings? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.