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 learn about Return on Equity using a real-life example.
With an ROE of 10.0%, Rosseti Public Joint Stock Company (MCX:RSTI) outpaced its own industry which delivered a less exciting 9.9% over the past year. Superficially, this looks great since we know that RSTI has generated big profits with little equity capital; however, ROE doesn’t tell us how much RSTI has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable RSTI’s ROE is.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Rosseti’s profit relative to its shareholders’ equity. An ROE of 10.0% implies RUB0.10 returned on every RUB1 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 Rosseti’s equity capital deployed. Its cost of equity is 20.2%. This means Rosseti’s returns actually do not cover its own cost of equity, with a discrepancy of -10.2%. This isn’t sustainable as it implies, very simply, that the company 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Rosseti’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Rosseti’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 37.3%, which means its above-average 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. Rosseti’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Rosseti, I’ve compiled three key 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 Rosseti 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 Rosseti is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Rosseti? 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.