The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
DNB ASA (OB:DNB) delivered an ROE of 11.3% over the past 12 months, which is an impressive feat relative to its industry average of 9.4% during the same period. Superficially, this looks great since we know that DNB has generated big profits with little equity capital; however, ROE doesn’t tell us how much DNB has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether DNB’s ROE is actually sustainable.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs DNB’s profit against the level of its shareholders’ equity. For example, if the company invests NOK1 in the form of equity, it will generate NOK0.11 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 DNB, which is 8.4%. Given a positive discrepancy of 2.9% between return and cost, this indicates that DNB pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue DNB can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check DNB’s historic debt-to-equity ratio. At over 2.5 times, DNB’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. DNB’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of DNB’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For DNB, I’ve compiled three key aspects 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.
- Valuation: What is DNB worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether DNB is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of DNB? 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.