Silverlake Axis Ltd (SGX:5CP) delivered an ROE of 77.05% over the past 12 months, which is an impressive feat relative to its industry average of 12.91% during the same period. 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. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 5CP’s ROE. See our latest analysis for Silverlake Axis

Breaking down Return on Equity

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. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

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 8.99%. Given a positive discrepancy of 68.06% between return and cost, this indicates that Silverlake Axis pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 Silverlake Axis 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 financial leverage can artificially inflate ROE, we need to look at how much debt Silverlake Axis currently has. The debt-to-equity ratio currently stands at a low 6.48%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

What this means for you:

Are you a shareholder? 5CP exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of 5CP to your portfolio if your personal research is confirming what the ROE is telling you. 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%.