KSH Holdings Limited’s (SGX:ER0) most recent return on equity was a substandard 8.33% relative to its industry performance of 8.47% over the past year. Though ER0’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 ER0’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ER0’s returns. Let me show you what I mean by this. Check out our latest analysis for KSH Holdings
Breaking down ROE — the mother of all ratios
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. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. KSH Holdings’s cost of equity is 8.51%. Since KSH Holdings’s return does not cover its cost, with a difference of -0.19%, this means its current use of equity is not efficient and not sustainable. Very simply, KSH Holdings 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from KSH Holdings’s 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 inflated by excessive debt, we need to examine KSH Holdings’s debt-to-equity level. At 33.93%, KSH Holdings’s debt-to-equity ratio appears low and indicates that KSH Holdings still has room to increase leverage and grow its profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. KSH Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of KSH Holdings’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.