I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Compagnie de Saint-Gobain SA (EPA:SGO) delivered an ROE of 10.9% over the past 12 months, which is an impressive feat relative to its industry average of 10.2% during the same period. Superficially, this looks great since we know that SGO has generated big profits with little equity capital; however, ROE doesn’t tell us how much SGO has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SGO’s ROE.
What you must know about ROE
Return on Equity (ROE) is a measure of Compagnie de Saint-Gobain’s profit relative to its shareholders’ equity. An ROE of 10.9% implies €0.11 returned on every €1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making 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 Compagnie de Saint-Gobain, which is 8.2%. This means Compagnie de Saint-Gobain returns enough to cover its own cost of equity, with a buffer of 2.7%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Compagnie de Saint-Gobain can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Compagnie de Saint-Gobain’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 59.9%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
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. Compagnie de Saint-Gobain exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Compagnie de Saint-Gobain, I’ve put together three fundamental 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 Compagnie de Saint-Gobain 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 Compagnie de Saint-Gobain is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Compagnie de Saint-Gobain? 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 email@example.com.