In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
InnoTek Limited (SGX:M14) delivered an ROE of 9.0% over the past 12 months, which is an impressive feat relative to its industry average of 8.1% during the same period. While the impressive ratio tells us that M14 has made significant profits from little equity capital, ROE doesn’t tell us if M14 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether M14’s ROE is actually sustainable.
View our latest analysis for InnoTek
Breaking down Return on Equity
Return on Equity (ROE) weighs InnoTek’s profit against the level of its shareholders’ equity. An ROE of 9.0% implies SGD0.090 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
Returns are usually compared to costs to measure the efficiency of capital. InnoTek’s cost of equity is 8.6%. Given a positive discrepancy of 0.4% between return and cost, this indicates that InnoTek pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue InnoTek can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check InnoTek’s historic debt-to-equity ratio. Currently InnoTek has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. InnoTek exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.