Retail Food Group Limited (ASX:RFG) outperformed the Restaurants industry on the basis of its ROE – producing a higher 14.72% relative to the peer average of 11.89% over the past 12 months. On the surface, this looks fantastic since we know that RFG has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable RFG’s ROE is. See our latest analysis for RFG
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of RFG’s profit relative to its shareholders’ equity. An ROE of 14.72% implies $0.15 returned on every $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
Returns are usually compared to costs to measure the efficiency of capital. RFG’s cost of equity is 8.55%. Since RFG’s return covers its cost in excess of 6.17%, its use of equity capital is efficient and likely to be sustainable. Simply put, RFG pays less 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient RFG is with its cost management. Asset turnover reveals how much revenue can be generated from RFG’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check RFG’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 54.13%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? RFG’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of RFG to your portfolio if your personal research is confirming what the ROE is telling you. 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%.