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 begin learning the link between Elia System Operator SA (EBR:ELI)’s return fundamentals and stock market performance.
Elia System Operator SA (EBR:ELI) outperformed the Electric Utilities industry on the basis of its ROE – producing a higher 8.67% relative to the peer average of 8.67% over the past 12 months. Superficially, this looks great since we know that ELI has generated big profits with little equity capital; however, ROE doesn’t tell us how much ELI has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ELI’s ROE. Check out our latest analysis for Elia System Operator
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Elia System Operator’s profit against the level of its shareholders’ equity. An ROE of 8.67% implies €0.087 returned on every €1 invested. 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 Elia System Operator, which is 8.39%. Given a positive discrepancy of 0.28% between return and cost, this indicates that Elia System Operator pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Elia System Operator can make from its 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 Elia System Operator’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 109.18%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Elia System Operator’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Elia System Operator, I’ve compiled three essential aspects 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.
- Future Earnings: How does Elia System Operator’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Elia System Operator? 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 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.