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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
Vicat SA (EPA:VCT) delivered a less impressive 7.4% ROE over the past year, compared to the 9.4% return generated by its industry. VCT’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on VCT’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of VCT’s returns.
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. For example, if the company invests €1 in the form of equity, it will generate €0.074 in earnings from this. 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. Vicat’s cost of equity is 9.9%. Since Vicat’s return does not cover its cost, with a difference of -2.5%, this means its current use of equity is not efficient and not sustainable. Very simply, Vicat pays more for its capital than what it generates 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. Asset turnover shows how much revenue Vicat can generate with its current 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 ROE can be artificially increased through excessive borrowing, we should check Vicat’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 50.9%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Vicat exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Vicat, I’ve compiled three relevant aspects you should further research:
- 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 Vicat 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 Vicat is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Vicat? 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.