Kencana Agri Limited (SGX:BNE) delivered an ROE of 27.89% over the past 12 months, which is an impressive feat relative to its industry average of 9.26% during the same period. On the surface, this looks fantastic since we know that BNE has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether BNE’s ROE is actually sustainable. View our latest analysis for Kencana Agri
What you must know about ROE
Return on Equity (ROE) is a measure of BNE’s profit relative to its shareholders’ equity. It essentially shows how much BNE 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
Returns are usually compared to costs to measure the efficiency of capital. BNE’s cost of equity is 15.04%. Given a positive discrepancy of 12.85% between return and cost, this indicates that BNE pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from BNE’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 BNE’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt BNE currently has. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
What this means for you:
Are you a shareholder? BNE exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more BNE shares. 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%.