Serial System Ltd’s (SGX:S69) most recent return on equity was a substandard 11.31% relative to its industry performance of 11.65% over the past year. S69’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 S69’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of S69’s returns. Let me show you what I mean by this. See our latest analysis for Serial System
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Serial System’s profit against the level of its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.11 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Serial System’s equity capital deployed. Its cost of equity is 10.96%. While Serial System’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 Serial System which is encouraging. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Serial System can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Serial System’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a high 153.82%, meaning the below-average ratio is already being driven by a large amount of debt.
What this means for you:
Are you a shareholder? While S69 exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. However, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of S69 to your portfolio. 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%.