This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Zespól Elektrowni Patnów-Adamów-Konin SA’s (WSE:ZEP) most recent return on equity was a substandard 5.0% relative to its industry performance of 5.1% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into ZEP’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ZEP’s returns.
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests PLN1 in the form of equity, it will generate PLN0.050 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 Zespól Elektrowni Patnów-Adamów-Konin, which is 8.8%. Given a discrepancy of -3.8% between return and cost, this indicated that Zespól Elektrowni Patnów-Adamów-Konin may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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 Zespól Elektrowni Patnów-Adamów-Konin can generate with its current 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 Zespól Elektrowni Patnów-Adamów-Konin’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 27.4%, meaning Zespól Elektrowni Patnów-Adamów-Konin still has headroom to borrow debt to increase profits.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Zespól Elektrowni Patnów-Adamów-Konin’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 Zespól Elektrowni Patnów-Adamów-Konin’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Zespól Elektrowni Patnów-Adamów-Konin, there are three key aspects 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 Zespól Elektrowni Patnów-Adamów-Konin 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 Zespól Elektrowni Patnów-Adamów-Konin is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Zespól Elektrowni Patnów-Adamów-Konin? 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.