Oldfields Holdings Limited (ASX:OLH) generated a below-average return on equity of 7.73% in the past 12 months, while its industry returned 10.83%. Though OLH'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 OLH's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of OLH's returns. See our latest analysis for OLH
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of OLH’s profit relative to its shareholders’ equity. An ROE of 7.73% implies $0.08 returned on every $1 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 measured against cost of equity in order to determine the efficiency of OLH’s equity capital deployed. Its cost of equity is 8.55%. This means OLH’s returns actually do not cover its own cost of equity, with a discrepancy of -0.82%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient OLH is with its cost management. Asset turnover shows how much revenue OLH 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 OLH’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check OLH’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a high 154.46%, which means its below-average ROE is already being driven by significant debt levels.
What this means for you:
Are you a shareholder? OLH’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more OLH shares.