CDL Hospitality Trusts (SGX:J85) outperformed the Hotel and Resort REITs industry on the basis of its ROE – producing a higher 7.00% relative to the peer average of 6.90% over the past 12 months. Superficially, this looks great since we know that J85 has generated big profits with little equity capital; however, ROE doesn’t tell us how much J85 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable J85’s ROE is. Check out our latest analysis for CDL Hospitality Trusts

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.07 in earnings from this. 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

Returns are usually compared to costs to measure the efficiency of capital. CDL Hospitality Trusts’s cost of equity is 8.38%. Since CDL Hospitality Trusts’s return does not cover its cost, with a difference of -1.38%, this means its current use of equity is not efficient and not sustainable. Very simply, CDL Hospitality Trusts 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 reveals how much revenue can be generated from CDL Hospitality Trusts’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine CDL Hospitality Trusts’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 50.41%, which means its above-average ROE is driven by its ability to grow its profit without a significant 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. CDL Hospitality Trusts’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.

For CDL Hospitality Trusts, I’ve put together three fundamental factors you should further examine:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Valuation: What is CDL Hospitality Trusts worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether CDL Hospitality Trusts is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of CDL Hospitality Trusts? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.