Spindex Industries Limited (SGX:564) delivered an ROE of 10.75% over the past 12 months, which is an impressive feat relative to its industry average of 7.34% during the same period. Superficially, this looks great since we know that 564 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 564 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable 564’s ROE is. See our latest analysis for Spindex Industries
What you must know about ROE
Return on Equity (ROE) is a measure of Spindex Industries’s profit relative to its shareholders’ equity. An ROE of 10.75% implies SGD0.11 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. Spindex Industries’s cost of equity is 9.19%. Given a positive discrepancy of 1.56% between return and cost, this indicates that Spindex Industries 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Spindex Industries can make from its 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 ROE can be inflated by excessive debt, we need to examine Spindex Industries’s debt-to-equity level. Currently, Spindex Industries has no debt which means its returns are driven purely 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 a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Spindex Industries’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.