The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Viva Energy Group Limited (ASX:VEA) delivered an ROE of 13.0% over the past 12 months, which is an impressive feat relative to its industry average of 10.0% during the same period. While the impressive ratio tells us that VEA has made significant profits from little equity capital, ROE doesn’t tell us if VEA has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable VEA’s ROE is.
View our latest analysis for Viva Energy Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Viva Energy Group’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.13 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
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 Viva Energy Group, which is 10.3%. Given a positive discrepancy of 2.7% between return and cost, this indicates that Viva Energy Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 Viva Energy Group can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Viva Energy Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 13.0%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.