Ryobi Kiso Holdings Ltd (SGX:BDN) delivered a less impressive 1.06% ROE over the past year, compared to the 8.42% return generated by its industry. BDN’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 BDN’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BDN’s returns. See our latest analysis for BDN
What you must know about ROE
Return on Equity (ROE) weighs BDN’s profit against the level of its shareholders’ equity. For example, if BDN invests SGD1 in the form of equity, it will generate SGD0.01 in earnings from this. 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 BDN’s equity capital deployed. Its cost of equity is 15.35%. Since BDN’s return does not cover its cost, with a difference of -14.29%, this means its current use of equity is not efficient and not sustainable. Very simply, BDN 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 BDN 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 BDN’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine BDN’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 108.41%, 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? BDN’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as BDN 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%.