Capgemini SE’s (ENXTPA:CAP) most recent return on equity was a substandard 11.61% relative to its industry performance of 13.81% over the past year. CAP’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on CAP’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CAP’s returns. See our latest analysis for Capgemini
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Capgemini’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.12 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 measured against cost of equity in order to determine the efficiency of Capgemini’s equity capital deployed. Its cost of equity is 8.34%. Some of Capgemini’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Capgemini which is reassuring. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Capgemini can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Capgemini’s debt-to-equity level. At 48.55%, Capgemini’s debt-to-equity ratio appears low and indicates that Capgemini still has room to increase leverage and grow its profits.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. While Capgemini exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Capgemini, there are three key factors you should look at:
- 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 Capgemini 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 Capgemini is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Capgemini? 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 pass 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.