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.
Serial System Ltd (SGX:S69) delivered an ROE of 8.9% over the past 12 months, which is an impressive feat relative to its industry average of 8.7% during the same period. Superficially, this looks great since we know that S69 has generated big profits with little equity capital; however, ROE doesn’t tell us how much S69 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable S69’s ROE is.
View our latest analysis for Serial System
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Serial System’s profit relative to its shareholders’ equity. An ROE of 8.9% implies SGD0.089 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. Serial System’s cost of equity is 17.4%. Given a discrepancy of -8.5% between return and cost, this indicated that Serial System 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 Serial System 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 inflated by excessive debt, we need to examine Serial System’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 148%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Serial System exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Although ROE can be a useful metric, it is only a small part of diligent research.