Global Invacom Group Limited (SGX:QS9) delivered a less impressive 5.32% ROE over the past year, compared to the 8.37% return generated by its industry. Though QS9’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 QS9’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of QS9’s returns. Check out our latest analysis for Global Invacom Group
What you must know about ROE
Return on Equity (ROE) is a measure of Global Invacom Group’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. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Global Invacom Group’s cost of equity is 10.05%. This means Global Invacom Group’s returns actually do not cover its own cost of equity, with a discrepancy of -4.74%. 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
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 Global Invacom Group 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 Global Invacom Group’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 14.47%, which means Global Invacom Group still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Global Invacom Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. 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.