I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 18.0%, APN Promise SA (WSE:PRO) outpaced its own industry which delivered a less exciting 11.9% over the past year. Superficially, this looks great since we know that PRO has generated big profits with little equity capital; however, ROE doesn’t tell us how much PRO has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of PRO’s ROE.
Peeling the layers of ROE – trisecting a company’s profitability
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 PLN0.18 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 A.P.N. Promise, which is 8.7%. This means A.P.N. Promise returns enough to cover its own cost of equity, with a buffer of 9.3%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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 reveals how much revenue can be generated from A.P.N. Promise’s 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 financial leverage can artificially inflate ROE, we need to look at how much debt A.P.N. Promise currently has. The debt-to-equity ratio currently stands at a sensible 85.5%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. A.P.N. Promise’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For A.P.N. Promise, there are three relevant 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 A.P.N. Promise 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 A.P.N. Promise is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of A.P.N. Promise? 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.