Why VICOM Ltd (SGX:V01) Looks Like A Quality Company

While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We’ll use ROE to examine VICOM Ltd (SGX:V01), by way of a worked example.

Over the last twelve months VICOM has recorded a ROE of 22%. That means that for every SGD1 worth of shareholders’ equity, it generated SGD0.22 in profit.

View our latest analysis for VICOM

How Do I Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity

Or for VICOM:

22% = S$29m ÷ S$132m (Based on the trailing twelve months to December 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.

What Does ROE Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.

Does VICOM Have A Good ROE?

By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, VICOM has a higher ROE than the average (5.8%) in the Commercial Services industry.

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That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.

Why You Should Consider Debt When Looking At ROE

Most companies need money — from somewhere — to grow their profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining VICOM’s Debt And Its 22% Return On Equity

Shareholders will be pleased to learn that VICOM has not one iota of net debt! Its high ROE indicates the business is high quality, but the fact that this was achieved without leverage is veritably impressive. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.

The Key Takeaway

Return on equity is one way we can compare the business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. Check the past profit growth by VICOM by looking at this visualization of past earnings, revenue and cash flow.

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