United Industrial Corporation Limited’s (SGX:U06) most recent return on equity was a substandard 4.40% relative to its industry performance of 6.97% over the past year. U06’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on U06’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of U06’s returns. View our latest analysis for United Industrial
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. An ROE of 4.40% implies SGD0.04 returned on every SGD1 invested. 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
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 United Industrial, which is 8.38%. This means United Industrial’s returns actually do not cover its own cost of equity, with a discrepancy of -3.97%. 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 shows how much revenue United Industrial can generate with its current 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 ROE can be inflated by excessive debt, we need to examine United Industrial’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 6.87%, meaning United Industrial still has headroom to borrow debt to increase profits.