This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
With an ROE of 16.7%, Central European Media Enterprises Ltd (NASDAQ:CETV) outpaced its own industry which delivered a less exciting 15.7% over the past year. While the impressive ratio tells us that CETV has made significant profits from little equity capital, ROE doesn’t tell us if CETV has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CETV’s ROE is actually sustainable.
What you must know about ROE
Return on Equity (ROE) weighs Central European Media Enterprises’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.17 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 Central European Media Enterprises, which is 14.8%. This means Central European Media Enterprises returns enough to cover its own cost of equity, with a buffer of 1.8%. 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. The other component, asset turnover, illustrates how much revenue Central European Media Enterprises can make from its 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 Central European Media Enterprises’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 237%, meaning the above-average ratio is a result of a large amount of debt.
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. Central European Media Enterprises’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 Central European Media Enterprises’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Central European Media Enterprises, there are three relevant factors 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 Central European Media Enterprises 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 Central European Media Enterprises is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Central European Media Enterprises? 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.