Yongmao Holdings Limited (SGX:BKX) delivered a less impressive 4.14% ROE over the past year, compared to the 7.75% return generated by its industry. Though BKX’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 BKX’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of BKX’s returns. Let me show you what I mean by this. View our latest analysis for Yongmao Holdings

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Yongmao 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. 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

Returns are usually compared to costs to measure the efficiency of capital. Yongmao Holdings’s cost of equity is 17.11%. Since Yongmao Holdings’s return does not cover its cost, with a difference of -12.97%, this means its current use of equity is not efficient and not sustainable. Very simply, Yongmao Holdings 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. The other component, asset turnover, illustrates how much revenue Yongmao Holdings can make from its 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 Yongmao Holdings’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 37.77%, meaning Yongmao Holdings still has headroom to borrow debt 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. Yongmao Holdings exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.