Shinvest Holding Ltd’s (SGX:BJW) most recent return on equity was a substandard 1.65% relative to its industry performance of 10.74% over the past year. Though BJW’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on BJW’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of BJW’s returns. Let me show you what I mean by this. Check out our latest analysis for Shinvest Holding
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 1.65% 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for BJW, which is 14.26%. Since BJW’s return does not cover its cost, with a difference of -12.61%, this means its current use of equity is not efficient and not sustainable. Very simply, BJW pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from BJW’s 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 BJW’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt BJW currently has. Currently the debt-to-equity ratio stands at a low 46.16%, which means BJW still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? BJW’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as BJW 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%.