With an ROE of 22.93%, Warpaint London PLC (AIM:W7L) outpaced its own industry which delivered a less exciting 20.40% over the past year. While the impressive ratio tells us that W7L has made significant profits from little equity capital, ROE doesn’t tell us if W7L has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether W7L’s ROE is actually sustainable. View our latest analysis for Warpaint London
What you must know about ROE
Return on Equity (ROE) weighs W7L’s profit against the level of its shareholders’ equity. An ROE of 22.93% implies £0.23 returned on every £1 invested. 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 measured against cost of equity in order to determine the efficiency of W7L’s equity capital deployed. Its cost of equity is 8.30%. This means W7L returns enough to cover its own cost of equity, with a buffer of 14.63%. This sustainable practice implies that the company pays less for its capital than what it generates 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient W7L is with its cost management. The other component, asset turnover, illustrates how much revenue W7L can make from its 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 W7L’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine W7L’s debt-to-equity level. Currently, W7L has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? W7L’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of W7L to your portfolio if your personal research is confirming what the ROE is telling you. 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 W7L, 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 Warpaint London 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.