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Wheelock Properties (Singapore) Limited (SGX:M35) delivered a less impressive 3.68% ROE over the past year, compared to the 6.97% return generated by its industry. Though M35’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on M35’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of M35’s returns. Let me show you what I mean by this. See our latest analysis for Wheelock Properties (Singapore)
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 Wheelock Properties (Singapore), which is 8.38%. This means Wheelock Properties (Singapore)’s returns actually do not cover its own cost of equity, with a discrepancy of -4.69%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Wheelock Properties (Singapore) 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 Wheelock Properties (Singapore)’s debt-to-equity level. Currently, Wheelock Properties (Singapore) has no debt which means its returns are driven purely by equity capital. This could explain why Wheelock Properties (Singapore)’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.