This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Prima Industrie SpA (BIT:PRI) outperformed the Industrial Machinery industry on the basis of its ROE – producing a higher 14.23% relative to the peer average of 14.07% over the past 12 months. On the surface, this looks fantastic since we know that PRI has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of PRI’s ROE.
See our latest analysis for Prima Industrie
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Prima Industrie’s profit against the level of its shareholders’ equity. An ROE of 14.23% implies €0.14 returned on every €1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 Prima Industrie, which is 9.08%. This means Prima Industrie returns enough to cover its own cost of equity, with a buffer of 5.15%. This sustainable practice implies that the company pays less 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:
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. The other component, asset turnover, illustrates how much revenue Prima Industrie can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Prima Industrie currently has. Currently the debt-to-equity ratio stands at a balanced 103.66%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Prima Industrie exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.