UPP Holdings Limited (SGX:U09) outperformed the Paper Products industry on the basis of its ROE – producing a higher 16.50% relative to the peer average of 11.53% over the past 12 months. While the impressive ratio tells us that U09 has made significant profits from little equity capital, ROE doesn’t tell us if U09 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether U09’s ROE is actually sustainable. View our latest analysis for UPP Holdings
What you must know about ROE
Return on Equity (ROE) weighs UPP Holdings’s profit against the level of 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
Returns are usually compared to costs to measure the efficiency of capital. UPP Holdings’s cost of equity is 15.17%. Given a positive discrepancy of 1.34% between return and cost, this indicates that UPP Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
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 UPP Holdings can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine UPP Holdings’s debt-to-equity level. At 123.51%, UPP Holdings’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. UPP Holdings’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.