The Dust SA. (WSE:THD) delivered a less impressive 11.34% ROE over the past year, compared to the 14.76% return generated by its industry. Though THD’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on THD’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of THD’s returns. Let me show you what I mean by this. Check out our latest analysis for Dust
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Dust’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of Dust’s equity capital deployed. Its cost of equity is 8.67%. Dust’s ROE exceeds its cost by 2.68%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than Dust’s case of positive discrepancy. 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 Dust 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 inflated by excessive debt, we need to examine Dust’s debt-to-equity level. Currently, Dust has no debt which means its returns are driven purely by equity capital. This could explain why Dust’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Even though Dust returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Dust’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Dust, there are three key aspects 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.
- Future Earnings: How does Dust’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 Dust? 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.