This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between SPH REIT (SGX:SK6U)’s return fundamentals and stock market performance.
SPH REIT (SGX:SK6U) delivered an ROE of 6.48% over the past 12 months, which is relatively in-line with its industry average of 7.25% during the same period. But what is more interesting is whether SK6U can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SK6U’s returns. View out our latest analysis for SPH REIT
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 6.48% implies SGD0.065 returned on every SGD1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Retail REITs sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
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 SPH REIT, which is 8.51%. Since SPH REIT’s return does not cover its cost, with a difference of -2.03%, this means its current use of equity is not efficient and not sustainable. Very simply, SPH REIT 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:
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 reveals how much revenue can be generated from SPH REIT’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether SPH REIT is fuelling ROE by excessively raising debt. Ideally, SPH REIT should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 35.09%, meaning SPH REIT has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. SPH REIT exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of SPH REIT’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For SPH REIT, I’ve put together three essential factors you should further examine:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is SPH REIT worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether SPH REIT is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SPH REIT? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!