As investors, it’s not just enough to see our companies earn profits and share the spoils with us in the form of dividends. Ideally, we also want to see the companies we invest in deliver good returns on our money.
This is where Return on Equity can be a useful metric to look at. My Foolish colleague David Kuo calls it a “one-duck-eat-three-ways-meal” (I’ll have to check back with David, but it’s likely in the spirit of how the meat from a Peking-duck can be used to prepare two other dishes!) because the figure can be broken down into three other components.
These components in turn, can then provide us with useful insights into what makes the company tick.
ST Engineering (SGX: S63) is a S$13b engineering and defence company that supports the Singapore Armed Forces in addition to providing engineering services to the aerospace, electronics and marine sectors among others.
The company has a very high Return on Equity of 30%, thrice that of the average of 10% for the 30 companies that make up the Straits Times Index (SGX: ^STI). So, what gives ST Engineering that extra-juice to become three times as effective as the average company in making a profit on each shareholder-dollar?
For starters, it’s certainly not the company’s net income margin of 9%. It only makes a $9 profit for every $100 in sales while the average company in the market earns $19 in profit for every $100 in revenue. So, ST Engineering’s slim profit margins (less than half the market average) aren’t worth that much to cheer about.
ST Engineering’s asset turnover of 0.83 is also not particularly high, given the market’s average of around 0.5. The asset turnover measures the amount of sales generated from each dollar of asset a company holds.
Now, the leverage ratio, which is the amount of assets a company has acquired in relation to its equity, is where ST Engineering comes out tops. Beer brewer Thai Beverage (SGX: Y92) achieved its unusually high 45% Return on Equity by leveraging its equity by 2.4 times to acquire income-producing assets.
But that pales in comparison to ST Engineering’s leverage ratio of 4. With the market average at only 1.7, ST Engineering is taking on a lot more liabilities to earn its profits as compared to others.
With all three components, we now have a better picture of what powers ST Engineering’s very high Return on Equity of 30%. It has been achieved through a net profit margin of 9%, asset turnover of 0.83 and a leverage ratio of 4.
Part of ST Engineering’s high leverage ratio is the result of it accepting payments from customers in advance of actual work being delivered. As of 31 March 2013, it had S$2.03b worth of goods and services to be delivered to its customers in the future even though payments have already been made.
It might be worthwhile for investors to keep an eye on ST Engineering’s ability to meet those deliverables.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.