Hanwell Holdings Limited (SGX:DM0) generated a below-average return on equity of 6.58% in the past 12 months, while its industry returned 7.76%. DM0’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 DM0’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of DM0’s returns. Check out our latest analysis for Hanwell Holdings
Breaking down ROE — the mother of all ratios
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. 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 Hanwell Holdings, which is 8.38%. Since Hanwell Holdings’s return does not cover its cost, with a difference of -1.79%, this means its current use of equity is not efficient and not sustainable. Very simply, Hanwell Holdings pays more for its capital than what it generates in return. ROE can be split up into three useful 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Hanwell Holdings can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Hanwell Holdings’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 17.46%, meaning Hanwell Holdings still has headroom to borrow debt to increase profits.