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 learn about Return on Equity using a real-life example.
With an ROE of 34.9%, International Consolidated Airlines Group SA (LON:IAG) outpaced its own industry which delivered a less exciting 21.2% over the past year. Superficially, this looks great since we know that IAG has generated big profits with little equity capital; however, ROE doesn’t tell us how much IAG has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable IAG’s ROE is.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs International Consolidated Airlines Group’s profit against the level of its shareholders’ equity. An ROE of 34.9% implies £0.35 returned on every £1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of International Consolidated Airlines Group’s equity capital deployed. Its cost of equity is 8.3%. Since International Consolidated Airlines Group’s return covers its cost in excess of 26.6%, its use of equity capital is efficient and likely to be sustainable. Simply put, International Consolidated Airlines Group 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue International Consolidated Airlines Group can generate with its current 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 International Consolidated Airlines Group’s historic debt-to-equity ratio. At 92.0%, International Consolidated Airlines Group’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. International Consolidated Airlines Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For International Consolidated Airlines Group, there are three important factors you should further examine:
- 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 International Consolidated Airlines Group 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 International Consolidated Airlines Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of International Consolidated Airlines Group? 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.