I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
PagSeguro Digital Ltd (NYSE:PAGS) generated a below-average return on equity of 12.7% in the past 12 months, while its industry returned 14.5%. PAGS’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 PAGS’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PAGS’s returns.
Breaking down Return on Equity
Return on Equity (ROE) weighs PagSeguro Digital’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.13 in earnings from this. 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 PagSeguro Digital, which is 9.7%. PagSeguro Digital’s ROE exceeds its cost by 2.9%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than PagSeguro Digital’s case of positive discrepancy. 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 reveals how much revenue can be generated from PagSeguro Digital’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt PagSeguro Digital currently has. Currently, PagSeguro Digital has no debt which means its returns are driven purely by equity capital. This could explain why PagSeguro Digital’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. While PagSeguro Digital 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For PagSeguro Digital, I’ve compiled three essential 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 PagSeguro Digital 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 PagSeguro Digital is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of PagSeguro Digital? 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.