Yeo Hiap Seng Limited (SGX:Y03) delivered an ROE of 25.16% over the past 12 months, which is an impressive feat relative to its industry average of 9.96% during the same period. While the impressive ratio tells us that Y03 has made significant profits from little equity capital, ROE doesn’t tell us if Y03 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable Y03’s ROE is. See our latest analysis for Yeo Hiap Seng

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Yeo Hiap Seng’s profit against the level of 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

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 Yeo Hiap Seng, which is 8.38%. Since Yeo Hiap Seng’s return covers its cost in excess of 16.79%, its use of equity capital is efficient and likely to be sustainable. Simply put, Yeo Hiap Seng pays less 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. The other component, asset turnover, illustrates how much revenue Yeo Hiap Seng can make from its 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 Yeo Hiap Seng currently has. Currently, Yeo Hiap Seng has no debt which means its returns are driven purely 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.

What this means for you:

Are you a shareholder? Y03’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of Y03 to your portfolio if your personal research is confirming what the ROE is telling you. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.

Are you a potential investor? If you are considering investing in Y03, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Yeo Hiap Seng to help you make a more informed investment decision.

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.