Sandon Capital Investments Limited (ASX:SNC) delivered a less impressive 7.62% ROE over the past year, compared to the 8.68% return generated by its industry. 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 SNC’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of SNC’s returns. Let me show you what I mean by this. See our latest analysis for Sandon Capital Investments
What you must know about ROE
Return on Equity (ROE) is a measure of Sandon Capital Investments’s profit relative to its 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. Sandon Capital Investments’s cost of equity is 8.55%. This means Sandon Capital Investments’s returns actually do not cover its own cost of equity, with a discrepancy of -0.93%. 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 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 reveals how much revenue can be generated from Sandon Capital Investments’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Sandon Capital Investments currently has. Currently, Sandon Capital Investments has no debt which means its returns are driven purely by equity capital. This could explain why Sandon Capital Investments’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.