With an ROE of 8.31%, Frasers Commercial Trust (SGX:ND8U) outpaced its own industry which delivered a less exciting 7.00% over the past year. While the impressive ratio tells us that ND8U has made significant profits from little equity capital, ROE doesn’t tell us if ND8U has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ND8U’s ROE is. Check out our latest analysis for Frasers Commercial Trust
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.08 in earnings from this. 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. Frasers Commercial Trust’s cost of equity is 8.38%. This means Frasers Commercial Trust’s returns actually do not cover its own cost of equity, with a discrepancy of -0.069%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Frasers Commercial Trust can generate with its current 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 Frasers Commercial Trust’s debt-to-equity level. At 58.40%, Frasers Commercial Trust’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Frasers Commercial Trust’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.