Why Metcash Limited’s (ASX:MTS) ROE Of 11.38% Does Not Tell The Whole Story
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and looking to gauge the potential return on investment in Metcash Limited (ASX:MTS).
Metcash Limited (ASX:MTS) generated a below-average return on equity of 11.38% in the past 12 months, while its industry returned 11.53%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into MTS’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of MTS’s returns. Let me show you what I mean by this. Check out our latest analysis for Metcash
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 11.38% implies A$0.11 returned on every A$1 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Metcash, which is 8.55%. Metcash’s ROE exceeds its cost by 2.83%, 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 Metcash’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:
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. The other component, asset turnover, illustrates how much revenue Metcash can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Metcash currently has. The debt-to-equity ratio currently stands at a low 7.71%, meaning Metcash still has headroom to borrow debt to increase profits.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. While Metcash exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Metcash’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 Metcash, I’ve put together three key 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 Metcash 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 Metcash is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Metcash? 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.
