This article is intended for those of you who are at the beginning of your investing journey and want a simplistic look at the return on Danieli & C Officine Meccaniche SpA (BIT:DAN) stock.
Danieli & C Officine Meccaniche SpA (BIT:DAN) generated a below-average return on equity of 1.80% in the past 12 months, while its industry returned 14.79%. DAN’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 DAN’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of DAN’s returns. See our latest analysis for Danieli & C. Officine Meccaniche
What you must know about ROE
Return on Equity (ROE) weighs Danieli & C. Officine Meccaniche’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.018 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 Danieli & C. Officine Meccaniche’s equity capital deployed. Its cost of equity is 8.83%. Given a discrepancy of -7.03% between return and cost, this indicated that Danieli & C. Officine Meccaniche may be paying more for its capital than what it’s generating in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Danieli & C. Officine Meccaniche can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Danieli & C. Officine Meccaniche’s historic debt-to-equity ratio. At 30.35%, Danieli & C. Officine Meccaniche’s debt-to-equity ratio appears low and indicates that Danieli & C. Officine Meccaniche 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. Danieli & C. Officine Meccaniche’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Danieli & C. Officine Meccaniche’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Danieli & C. Officine Meccaniche, there are three pertinent 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 Danieli & C. Officine Meccaniche 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 Danieli & C. Officine Meccaniche is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Danieli & C. Officine Meccaniche? 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.