Why Greencore Group plc’s (LSE:GNC) ROE Of 7.58% Does Not Tell The Whole Story
Greencore Group plc (LSE:GNC) generated a below-average return on equity of 7.58% in the past 12 months, while its industry returned 12.26%. Though GNC'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 GNC's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GNC's returns. See our latest analysis for GNC
What you must know about ROE
Return on Equity (ROE) weighs GNC’s profit against the level of its shareholders’ equity. For example, if GNC invests £1 in the form of equity, it will generate £0.08 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
ROE is measured against cost of equity in order to determine the efficiency of GNC’s equity capital deployed. Its cost of equity is 8.30%. Since GNC’s return does not cover its cost, with a difference of -0.72%, this means its current use of equity is not efficient and not sustainable. Very simply, GNC 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:
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 GNC 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 GNC’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine GNC’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 81.33%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? GNC’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means GNC still has room to improve shareholder returns by raising debt to fund new investments. If you're looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in GNC, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Greencore Group to help you make a more informed investment decision.
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.
