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.
Darco Water Technologies Limited’s (SGX:BLR) most recent return on equity was a substandard 1.61% relative to its industry performance of 7.15% over the past year. 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 BLR’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BLR’s returns.
View our latest analysis for Darco Water Technologies
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Darco Water Technologies’s profit against the level of its shareholders’ equity. An ROE of 1.61% implies SGD0.016 returned on every SGD1 invested. 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. Darco Water Technologies’s cost of equity is 9.54%. Since Darco Water Technologies’s return does not cover its cost, with a difference of -7.93%, this means its current use of equity is not efficient and not sustainable. Very simply, Darco Water Technologies 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Darco Water Technologies can generate with its current 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 artificially increased through excessive borrowing, we should check Darco Water Technologies’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 16.54%, meaning Darco Water Technologies still has headroom to borrow debt to increase profits.