OUE Hospitality Trust’s (SGX:SK7) most recent return on equity was a substandard 1.70% relative to its industry performance of 7.02% over the past year. Though SK7’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 SK7’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SK7’s returns. View our latest analysis for OUE Hospitality Trust

What you must know about ROE

Return on Equity (ROE) is a measure of OUE Hospitality Trust’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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

ROE is measured against cost of equity in order to determine the efficiency of OUE Hospitality Trust’s equity capital deployed. Its cost of equity is 8.38%. Given a discrepancy of -6.67% between return and cost, this indicated that OUE Hospitality Trust may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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 OUE Hospitality Trust 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 financial leverage can artificially inflate ROE, we need to look at how much debt OUE Hospitality Trust currently has. The debt-to-equity ratio currently stands at a sensible 62.79%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.

What this means for you:

Are you a shareholder? SK7’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means SK7 still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.