This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Laboratorios Farmaceuticos Rovi SA (BME:ROVI) delivered a less impressive 4.7% ROE over the past year, compared to the 11.5% return generated by its industry. ROVI’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 ROVI’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ROVI’s returns. Let me show you what I mean by this.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Laboratorios Farmaceuticos Rovi’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Laboratorios Farmaceuticos Rovi’s equity capital deployed. Its cost of equity is 8.3%. Since Laboratorios Farmaceuticos Rovi’s return does not cover its cost, with a difference of -3.6%, this means its current use of equity is not efficient and not sustainable. Very simply, Laboratorios Farmaceuticos Rovi pays more for its capital than what it generates in return. ROE can be split up into three useful 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 reveals how much revenue can be generated from Laboratorios Farmaceuticos Rovi’s 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 inflated by excessive debt, we need to examine Laboratorios Farmaceuticos Rovi’s debt-to-equity level. At 19.9%, Laboratorios Farmaceuticos Rovi’s debt-to-equity ratio appears low and indicates that Laboratorios Farmaceuticos Rovi 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. Laboratorios Farmaceuticos Rovi 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 Laboratorios Farmaceuticos Rovi, there are three essential 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 Laboratorios Farmaceuticos Rovi 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 Laboratorios Farmaceuticos Rovi is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Laboratorios Farmaceuticos Rovi? 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 firstname.lastname@example.org.