In This Article:
QinetiQ Group plc (LSE:QQ.) outperformed the Aerospace and Defense industry on the basis of its ROE – producing a higher 21.66% relative to the peer average of 11.34% over the past 12 months. While the impressive ratio tells us that QQ. has made significant profits from little equity capital, ROE doesn’t tell us if QQ. has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether QQ.’s ROE is actually sustainable. View our latest analysis for QinetiQ Group
What you must know about ROE
Return on Equity (ROE) weighs QinetiQ Group’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.22 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
Returns are usually compared to costs to measure the efficiency of capital. QinetiQ Group’s cost of equity is 8.30%. Given a positive discrepancy of 13.36% between return and cost, this indicates that QinetiQ Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue QinetiQ Group can generate with its current 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 QinetiQ Group currently has. Currently QinetiQ Group has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. QinetiQ Group 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.