Is Eurocell plc’s (LSE:ECEL) ROE Of 56.38% Sustainable?
Eurocell plc (LSE:ECEL) delivered an ROE of 56.38% over the past 12 months, which is an impressive feat relative to its industry average of 19.58% during the same period. On the surface, this looks fantastic since we know that ECEL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether ECEL’s ROE is actually sustainable. Check out our latest analysis for Eurocell
Breaking down Return on Equity
Return on Equity (ROE) is a measure of ECEL’s profit relative to its shareholders’ equity. For example, if ECEL invests £1 in the form of equity, it will generate £0.56 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
Returns are usually compared to costs to measure the efficiency of capital. ECEL’s cost of equity is 8.30%. This means ECEL returns enough to cover its own cost of equity, with a buffer of 48.08%. 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:
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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient ECEL is with its cost management. Asset turnover reveals how much revenue can be generated from ECEL’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable ECEL’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt ECEL currently has. The debt-to-equity ratio currently stands at a sensible 61.95%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? ECEL’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in ECEL, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Eurocell to help you make a more informed investment decision.
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.
