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This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
SUTL Enterprise Limited (SGX:BHU) generated a below-average return on equity of 6.8% in the past 12 months, while its industry returned 7.6%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into BHU’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of BHU’s returns. Let me show you what I mean by this.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs SUTL Enterprise’s profit against the level of its shareholders’ equity. An ROE of 6.8% implies SGD0.068 returned on every SGD1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. SUTL Enterprise’s cost of equity is 8.6%. Given a discrepancy of -1.8% between return and cost, this indicated that SUTL Enterprise 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 reveals how much revenue can be generated from SUTL Enterprise’s 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 SUTL Enterprise’s historic debt-to-equity ratio. Currently, SUTL Enterprise has no debt which means its returns are driven purely by equity capital. This could explain why SUTL Enterprise’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. SUTL Enterprise exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of SUTL Enterprise’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.