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Singapore Technologies Engineering Ltd (SGX:S63) outperformed the Aerospace and Defense industry on the basis of its ROE – producing a higher 21.24% relative to the peer average of 14.31% over the past 12 months. Superficially, this looks great since we know that S63 has generated big profits with little equity capital; however, ROE doesn’t tell us how much S63 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable S63’s ROE is. See our latest analysis for Singapore Technologies Engineering
What you must know about ROE
Return on Equity (ROE) is a measure of Singapore Technologies Engineering’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 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 Singapore Technologies Engineering, which is 9.84%. This means Singapore Technologies Engineering returns enough to cover its own cost of equity, with a buffer of 11.40%. This sustainable practice implies that the company pays less 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 Singapore Technologies Engineering can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Singapore Technologies Engineering currently has. At 44.26%, Singapore Technologies Engineering’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.