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.
Hollywood Bowl Group plc (LON:BOWL) outperformed the Leisure Facilities industry on the basis of its ROE – producing a higher 22.1% relative to the peer average of 10.8% over the past 12 months. On the surface, this looks fantastic since we know that BOWL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BOWL’s ROE is.
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 22.1% implies £0.22 returned on every £1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 Hollywood Bowl Group, which is 8.3%. Since Hollywood Bowl Group’s return covers its cost in excess of 13.8%, its use of equity capital is efficient and likely to be sustainable. Simply put, Hollywood Bowl Group 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 the business is with its cost management. The other component, asset turnover, illustrates how much revenue Hollywood Bowl Group 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Hollywood Bowl Group currently has. At 31.8%, Hollywood Bowl Group’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Hollywood Bowl Group’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. Although ROE can be a useful metric, it is only a small part of diligent research.
For Hollywood Bowl Group, there are three relevant 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.
- Valuation: What is Hollywood Bowl Group 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 Hollywood Bowl Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Hollywood Bowl Group? 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.