This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Excelpoint Technology Ltd (SGX:BDF) performed in-line with its technology distributors industry on the basis of its ROE – producing a return of10.88% relative to the peer average of 10.74% over the past 12 months. However, whether this ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, BDF can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Excelpoint Technology’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.11 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Technology Distributors sector by choosing 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 Excelpoint Technology, which is 17.44%. Given a discrepancy of -6.56% between return and cost, this indicated that Excelpoint Technology may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Excelpoint Technology can make from its 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 the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Excelpoint Technology’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a high 198.85%, meaning Excelpoint Technology may have taken on a disproportionate level of debt which is driving the high return. The company’s ability to produce profit growth may hinge on its big debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Excelpoint Technology exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Excelpoint Technology, I’ve compiled three important factors you should further research:
- 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.
- Future Earnings: How does Excelpoint Technology’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Excelpoint Technology? 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 past 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.