LHT Holdings Limited (SGX:BEI) generated a below-average return on equity of 5.82% in the past 12 months, while its industry returned 11.33%. 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 BEI’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BEI’s returns. View our latest analysis for LHT Holdings

Breaking down Return on Equity

Return on Equity (ROE) is a measure of LHT Holdings’s profit relative to its 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 measured against cost of equity in order to determine the efficiency of LHT Holdings’s equity capital deployed. Its cost of equity is 9.43%. Given a discrepancy of -3.61% between return and cost, this indicated that LHT Holdings may be paying more for its capital than what it’s generating 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 LHT Holdings 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 ROE can be inflated by excessive debt, we need to examine LHT Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 1.66%, which means LHT Holdings still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? BEI’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means BEI still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.