The return on equity (ROE) metric is an important thing for investors to look at. It gives insight on a company’s ability to generate a profit using the shareholder’s capital it has. In general, the higher a company’s ROE is, the better. But, it’s also worth noting that the use of high leverage – which increases the financial risks a company is facing – can also increase a company’s ROE. So, that’s something to keep an eye on. In 2016, Sheng Siong Group Ltd (SGX: OV8) generated a high ROE of 24.6% (more on this later). The company is a…
The return on equity (ROE) metric is an important thing for investors to look at. It gives insight on a company’s ability to generate a profit using the shareholder’s capital it has. In general, the higher a company’s ROE is, the better.
But, it’s also worth noting that the use of high leverage – which increases the financial risks a company is facing – can also increase a company’s ROE. So, that’s something to keep an eye on.
In 2016, Sheng Siong Group Ltd (SGX: OV8) generated a high ROE of 24.6% (more on this later). The company is a supermarket operator and it currently has a network of 42 stores in Singapore that are primarily located in the heartlands. It has over 30 years of experience, having been in business since 1985.
Right now, the median trailing ROE for the 30 companies that make up Singapore’s stock market benchmark, the Straits Times Index (SGX: ^STI), is less than 10%, according to data from S&P Global Market Intelligence. This shows us how impressive Sheng Siong’s ROE is.
But the company’s performance also raises a big question: Is its ROE sustainable? To answer the question, let’s look at the three components that make up Sheng Siong’s ROE, namely, the asset turnover, the net profit margin, and the leverage ratio.
The asset turnover
The asset turnover measures the efficiency of a company in using its assets to generate revenue. It is calculated by dividing a company’s total revenue by its assets. In 2016, Sheng Siong had total assets of S$387.8 million and revenue of S$796.7 million; this gives us an asset turnover of 2.05.
For perspective, Dairy Farm International Holdings Ltd (SGX: D01), a pan-Asian bricks-and-mortar retailer with a substantial supermarket and hypermarket business, had an asset turnover of 2.18 in 2016.
Sheng Siong’s asset turnover is thus roughly in line with its peer, which is a good thing, as it shows that this component of Sheng Siong’s ROE is not way above the norm. If it is way higher than usual, it could be a tall order for the company to maintain its performance.
The profit margin
The net profit margin measures the percentage of revenue that is left as a profit after deduction of all expenses. In 2016, the net profit margin for Sheng Siong is 7.87%, given its revenue and net profit of S$796.7 million and S$62.7 million, respectively.
The company’s net profit margin is on the high end since Dairy Farm’s operating margin in 2016 for it supermarket and hypermarket business is only 3.3%. It would thus be useful for investors find out whether Sheng Siong’s high profitability is due to its ability to charge higher prices for products in its stores or due to its operating efficiency. The former is less sustainable, especially if there’s rising competition.
It is reasonable to assume that Sheng Siong is not charging higher prices for products in its supermarkets. In 2016, the company’s gross profit margin is 25.7%, whereas Dairy Farm’s gross profit margin is 30.2%. It’s not an apple-to-apple comparison given that Dairy Farm has other retail businesses (such as pharmacies and home furnishing stores), but putting the two companies’ gross profit margins together still gives us useful insight.
Growth in other categories of expenses could harm Sheng Siong’s future profitability too. These categories include rental and staff costs. I think such costs would likely rise in the future, so it is important that investors keep an eye on this part of the equation.
The leverage ratio
The leverage ratio shows the relationship of a company’s total assets to its equity; it is calculated by dividing total assets by equity. A higher ratio means that a company is funding its assets with more liabilities, hence resulting in higher risk.
Sheng Siong had total assets of S$387.8 million and total equity of S$254.9 million in 2016, which results in a leverage ratio of 1.52. Not only is 1.52 a healthy figure, it’s worth noting that Sheng Siong currently employs zero debt to fund its assets.
Thus, the company can not only sustainably maintain its current gearing ratio, it can also, if necessary, borrow money to juice up its ROE. Of course, doing so will result in Sheng Siong being in a financially riskier position. So, if management does pursue such a strategy, investors would need to make sure management is keeping the risks in check.
A Foolish conclusion
When we put all the three numbers (the asset turnover, net profit margin, and leverage ratio) together, we arrive at the aforementioned ROE of 24.6% for Sheng Siong in 2016. And based on all that we’ve seen here, it is likely that Sheng Siong can sustain its high ROE going forward.
The situation can change of course, if competition becomes more intense, growth in expenses is not controlled, and shopping habits of consumers change drastically (for example, by buying more groceries and daily necessities online).
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of Dairy Farm International Holdings. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.