With an ROE of 16.18%, Silverlake Axis Ltd (SGX:5CP) outpaced its own industry which delivered a less exciting 13.11% over the past year. While the impressive ratio tells us that 5CP has made significant profits from little equity capital, ROE doesn’t tell us if 5CP has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 5CP’s ROE is actually sustainable. See our latest analysis for Silverlake Axis
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Silverlake Axis’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 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 Silverlake Axis, which is 9.27%. This means Silverlake Axis returns enough to cover its own cost of equity, with a buffer of 6.91%. This sustainable practice implies that the company pays less for its capital than what it generates 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. The other component, asset turnover, illustrates how much revenue Silverlake Axis can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Silverlake Axis’s historic debt-to-equity ratio. Currently Silverlake Axis has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Silverlake Axis’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.