InnoTek Limited’s (SGX:M14) most recent return on equity was a substandard 9.57% relative to its industry performance of 10.74% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into M14’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of M14’s returns. Let me show you what I mean by this. View our latest analysis for InnoTek
What you must know about ROE
Return on Equity (ROE) weighs InnoTek’s profit against the level of its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.1 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
ROE is measured against cost of equity in order to determine the efficiency of InnoTek’s equity capital deployed. Its cost of equity is 8.39%. InnoTek’s ROE exceeds its cost by 1.17%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than InnoTek’s case of positive discrepancy. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue InnoTek can generate with its current 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 InnoTek’s historic debt-to-equity ratio. Currently InnoTek has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why InnoTek’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? While M14 exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.