Hwa Hong Corporation Limited (SGX:H19) generated a below-average return on equity of 2.48% in the past 12 months, while its industry returned 6.62%. 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 H19’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of H19’s returns. Let me show you what I mean by this. View our latest analysis for Hwa Hong

What you must know about ROE

Return on Equity (ROE) weighs Hwa Hong’s profit against the level of its shareholders’ equity. An ROE of 2.48% implies SGD0.02 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

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 Hwa Hong, which is 8.51%. This means Hwa Hong’s returns actually do not cover its own cost of equity, with a discrepancy of -6.03%. 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 dissected into three distinct 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 Hwa Hong can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Hwa Hong currently has. Currently the debt-to-equity ratio stands at a low 34.16%, which means Hwa Hong still has headroom to take on more leverage in order to increase profits.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Hwa Hong 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 Hwa Hong’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.