Stockland Corporation Limited (ASX:SGP) generated a below-average return on equity of 12.46% in the past 12 months, while its industry returned 15.74%. Though SGP'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 SGP's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SGP's returns. Check out our latest analysis for Stockland

Breaking down Return on Equity

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if SGP invests $1 in the form of equity, it will generate $0.12 in earnings from this. 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. SGP’s cost of equity is 8.55%. SGP’s ROE exceeds its cost by 3.91%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than SGP’s case of positive discrepancy. 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 SGP is with its cost management. The other component, asset turnover, illustrates how much revenue SGP can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SGP’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine SGP’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 37.18%, which means SGP still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? Even though SGP returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of SGP to your portfolio if your personal research is confirming what the ROE is telling you.