The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 9.5%, Hiap Hoe Limited (SGX:5JK) outpaced its own industry which delivered a less exciting 6.4% over the past year. Superficially, this looks great since we know that 5JK has generated big profits with little equity capital; however, ROE doesn’t tell us how much 5JK has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 5JK’s ROE.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Hiap Hoe’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. Hiap Hoe’s cost of equity is 11.6%. Since Hiap Hoe’s return does not cover its cost, with a difference of -2.1%, this means its current use of equity is not efficient and not sustainable. Very simply, Hiap Hoe 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
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 Hiap Hoe can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Hiap Hoe’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 85.9%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Hiap Hoe’s ROE is impressive relative to the industry average, though its returns were not strong 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.