I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Golden Agri-Resources Ltd (SGX:E5H) delivered a less impressive 1.32% ROE over the past year, compared to the 8.99% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into E5H’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of E5H’s returns.

View our latest analysis for Golden Agri-Resources

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Golden Agri-Resources’s profit relative to its shareholders’ equity. An ROE of 1.32% implies SGD0.013 returned on every SGD1 invested. 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 Golden Agri-Resources, which is 8.51%. This means Golden Agri-Resources’s returns actually do not cover its own cost of equity, with a discrepancy of -7.20%. 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 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

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 reveals how much revenue can be generated from Golden Agri-Resources’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Golden Agri-Resources currently has. The debt-to-equity ratio currently stands at a sensible 75.48%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.