Hupsteel Limited (SGX:BMH) delivered a less impressive 3.31% ROE over the past year, compared to the 5.04% return generated by its industry. Though BMH’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on BMH’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BMH’s returns. Check out our latest analysis for Hupsteel
Breaking down Return on Equity
Return on Equity (ROE) is a measure of BMH’s profit relative to its shareholders’ equity. It essentially shows how much BMH can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of BMH’s equity capital deployed. Its cost of equity is 8.38%. Given a discrepancy of -5.06% between return and cost, this indicated that BMH 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 reveals how much revenue can be generated from BMH’s 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 BMH’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine BMH’s debt-to-equity level. Currently BMH has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why BMH’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? BMH’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as BMH still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.