This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Design Studio Group Ltd (SGX:D11) generated a below-average return on equity of 0.2% in the past 12 months, while its industry returned 11.3%. D11’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on D11’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of D11’s returns.
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What you must know about ROE
Return on Equity (ROE) is a measure of Design Studio Group’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.0022 in earnings from this. 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 Design Studio Group’s equity capital deployed. Its cost of equity is 8.5%. This means Design Studio Group’s returns actually do not cover its own cost of equity, with a discrepancy of -8.3%. 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 broken down into three different 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. The other component, asset turnover, illustrates how much revenue Design Studio Group 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 artificially increased through excessive borrowing, we should check Design Studio Group’s historic debt-to-equity ratio. Currently, Design Studio Group has no debt which means its returns are driven purely by equity capital. This could explain why Design Studio Group’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.