A Look At 1 Important Investing Formula For Old Chang Kee Ltd

The return on equity (ROE) metric measures a company’s ability to generate a profit with the shareholders’ capital it has. Generally speaking, a high ROE is preferred over a low one, all things being equal.

But as you can observe in the chart below, the ROE for Old Chang Kee Ltd (SGX: 5ML) has been declining over its last five fiscal years:

Old Chang Kee ROE chart - Wilson
Source: Old Chang Kee’s annual reports

Why has this happened? Let’s tease apart Old Chang Kee’s ROE to have a better idea of the drivers behind the phenomenon. The ROE can be broken down into three other components with the formula below:

ROE = Profit Margin x Asset Turnover x Equity Multiplier

The formula may be recognisable to some of you. It is the DuPont formula, created in the 1920s by the DuPont Corporation to measure its own internal efficiency.

Before we apply the DuPont analysis on Old Chang Kee, let’s first have a few quick words on the company’s business for some context. Old Chang Kee is a food & beverage retail outfit and most people living in Singapore are likely to be familiar with the signature Curry’O puffs sold in the company’s namesake retail outlets. Old Chang Kee has been around since 1956, growing from a single stall outside a cinema to 85 outlets across Singapore today.

So, what can the DuPont analysis tell us about Old Chang Kee’s ROE from FY2012 (fiscal year ended 31 March 2012) to FY2016? Let’s start with the first component, the profit margin:

Old Chang Kee profit margin chart - Wilson
Source: Old Chang Kee’s annual reports

Old Chang Kee’s profit margin rose from FY2012 to FY2014, but then started declining. That said, its profit margin in FY2016 is still higher than in FY2012. The company has managed to control its costs well.

Old Chang Kee asset turnover and equity multiplier chart - Wilson
Source: Old Chang Kee’s annual reports

The second component of the DuPont formula, the asset turnover, is a measure of how good Old Chang Kee is at utilizing its assets to generate revenue. It is calculated by dividing the company’s revenue with its assets. Generally, a higher asset turnover translates to a better performance.

You can see that Old Chang Kee’s asset turnover has declined from FY2012 (2.21) to FY2016 (1.35). A quick look at the curry puff purveyor’s annual report shows that even though its revenue has increased, from S$66 million in FY2013 to S$74 million in FY2016, its assets have increased at an even faster pace from S$41 million in FY2013 to S$54 million in FY2016.

Much of this increase in assets can be attributed to the investments in plant and equipment that Old Chang Kee had made in those years. On the company’s balance sheet, the property, plant, and equipment account had increased from S$19 million in FY2012 to S$29 million in FY2016.

A falling asset turnover is not necessarily undesirable if the company is investing to be more efficient in the future.

The last component of the DuPont formula is the equity multiplier and it is found by dividing a company’s assets with its equity. It is a gauge for how much leverage – and thus financial risk – Old Chang Kee is taking on.

Generally, higher leverage results in a better return on equity at the expense of a weaker balance sheet.

Old Chang Kee’s equity multiplier has increased slightly from 1.41 in FY2012 to 1.57 in FY2016. At the end of FY2016, Old Chang Kee carried S$9.8 million more in liabilities on its balance sheet as compared to FY2012. But, the curry puff seller’s balance sheet remains in a net-cash position at FY2016.

A Fool’s take

To sum up, the DuPont analysis has showed us that Old Chang Kee’s declining ROE is mainly caused by its lower asset turnover, which is the result of heavy investments made into plant and equipment. Nonetheless, Old Chang Kee ended FY2016 with a ROE of 14%, which is higher compared to many of the constituent stocks of the Straits Times Index (SGX: ^STI).

Having said all that, it’s worth noting that a company’s historical performance is not a perfect indicator of the future. More work beyond the DuPont analysis also needs to be done before any firm investing conclusion can be made on Old Chang Kee. This look at the company’s ROE should only be seen as a useful starting point for further research.

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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 Wilson Ong doesn’t own shares in any companies mentioned.