In This Article:
Servcorp Limited (ASX:SRV) generated a below-average return on equity of 9.90% in the past 12 months, while its industry returned 11.22%. SRV’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 SRV’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SRV’s returns. Let me show you what I mean by this. See our latest analysis for Servcorp
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. It essentially shows how much the company 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. Servcorp’s cost of equity is 8.55%. While Servcorp’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Servcorp which is encouraging. 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 Servcorp 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 ROE can be inflated by excessive debt, we need to examine Servcorp’s debt-to-equity level. Currently Servcorp has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Servcorp’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Although Servcorp’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Servcorp’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.