United Engineers Limited’s (SGX:U04) most recent return on equity was a substandard 2.21% relative to its industry performance of 8.42% over the past year. U04’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 U04’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of U04’s returns. Check out our latest analysis for United Engineers
Breaking down Return on Equity
Return on Equity (ROE) is a measure of United Engineers’s profit relative to its shareholders’ equity. An ROE of 2.21% implies SGD0.02 returned on every SGD1 invested. 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 United Engineers’s equity capital deployed. Its cost of equity is 9.58%. This means United Engineers’s returns actually do not cover its own cost of equity, with a discrepancy of -7.37%. This isn’t sustainable as it implies, very simply, that the company pays more 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. Asset turnover shows how much revenue United Engineers 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 United Engineers currently has. Currently the debt-to-equity ratio stands at a low 38.89%, which means United Engineers still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? U04 exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as U04 still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.