Cache Logistics Trust (SGX:K2LU) generated a below-average return on equity of 1.21% in the past 12 months, while its industry returned 7.02%. 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 K2LU’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of K2LU’s returns. See our latest analysis for Cache Logistics Trust
What you must know about ROE
Return on Equity (ROE) is a measure of Cache Logistics Trust’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.01 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. Cache Logistics Trust’s cost of equity is 8.38%. Since Cache Logistics Trust’s return does not cover its cost, with a difference of -7.17%, this means its current use of equity is not efficient and not sustainable. Very simply, Cache Logistics Trust 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. Asset turnover shows how much revenue Cache Logistics Trust 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 financial leverage can artificially inflate ROE, we need to look at how much debt Cache Logistics Trust currently has. Currently the debt-to-equity ratio stands at a reasonable 78.47%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? K2LU’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means K2LU still has room to improve shareholder returns by raising debt to fund new investments. 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%.