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.
M&C Saatchi plc’s (LON:SAA) most recent return on equity was a substandard 5.3% relative to its industry performance of 7.3% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into SAA’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SAA’s returns.
What you must know about ROE
Return on Equity (ROE) weighs M&C Saatchi’s profit against the level of its shareholders’ equity. An ROE of 5.3% implies £0.053 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
Returns are usually compared to costs to measure the efficiency of capital. M&C Saatchi’s cost of equity is 8.3%. Given a discrepancy of -3.0% between return and cost, this indicated that M&C Saatchi may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue M&C Saatchi 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 M&C Saatchi currently has. At 37.0%, M&C Saatchi’s debt-to-equity ratio appears low and indicates that M&C Saatchi still has room to increase leverage and grow its profits.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. M&C Saatchi exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of M&C Saatchi’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For M&C Saatchi, I’ve compiled three key factors you should look at:
- 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 M&C Saatchi 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 M&C Saatchi is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of M&C Saatchi? 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.