Kencana Agri Limited (SGX:BNE) delivered an ROE of 10.27% over the past 12 months, which is an impressive feat relative to its industry average of 7.76% during the same period. On the surface, this looks fantastic since we know that BNE has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of BNE’s ROE. See our latest analysis for Kencana Agri
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Kencana Agri’s profit against the level of 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 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 Kencana Agri, which is 16.55%. This means Kencana Agri’s returns actually do not cover its own cost of equity, with a discrepancy of -6.28%. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Kencana Agri 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 Kencana Agri’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Kencana Agri’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of Kencana Agri’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.