SP Corporation Limited’s (SGX:AWE) most recent return on equity was a substandard 1.90% relative to its industry performance of 2.54% over the past year. AWE’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on AWE’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of AWE’s returns. Let me show you what I mean by this. View our latest analysis for SP
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of SP’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.02 in earnings from this. 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 SP’s equity capital deployed. Its cost of equity is 8.38%. Given a discrepancy of -6.48% between return and cost, this indicated that SP may be paying more for its capital than what it’s generating 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue SP can generate with its current 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 SP’s historic debt-to-equity ratio. Currently, SP has no debt which means its returns are driven purely by equity capital. This could explain why SP’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. SP’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.