I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 4.27%, Suntec Real Estate Investment Trust (SGX:T82U) returned in-line to its own industry which delivered 6.28% over the past year. But what is more interesting is whether T82U 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 T82U’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Suntec Real Estate Investment Trust’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.043 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Diversified 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 measured against cost of equity in order to determine the efficiency of Suntec Real Estate Investment Trust’s equity capital deployed. Its cost of equity is 8.51%. Since Suntec Real Estate Investment Trust’s return does not cover its cost, with a difference of -4.24%, this means its current use of equity is not efficient and not sustainable. Very simply, Suntec Real Estate Investment Trust 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
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 shows how much revenue Suntec Real Estate Investment Trust can generate with its current 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 determine if Suntec Real Estate Investment Trust’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Suntec Real Estate Investment Trust’s debt-to-equity ratio. The ratio currently stands at a sensible 56.38%, meaning Suntec Real Estate Investment Trust has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Suntec Real Estate Investment Trust exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Suntec Real Estate Investment Trust, I’ve put together three relevant aspects you should look at:
- 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 Suntec Real Estate Investment Trust 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 Suntec Real Estate Investment Trust is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Suntec Real Estate Investment Trust? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.