With an ROE of 12.54%, Azkoyen SA. (BME:AZK) outpaced its own industry which delivered a less exciting 10.60% over the past year. While the impressive ratio tells us that AZK has made significant profits from little equity capital, ROE doesn’t tell us if AZK has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable AZK’s ROE is. View our latest analysis for Azkoyen
What you must know about ROE
Return on Equity (ROE) weighs Azkoyen’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.13 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. Azkoyen’s cost of equity is 8.36%. Since Azkoyen’s return covers its cost in excess of 4.18%, its use of equity capital is efficient and likely to be sustainable. Simply put, Azkoyen 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
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 Azkoyen 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 ROE can be artificially increased through excessive borrowing, we should check Azkoyen’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 8.27%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Azkoyen’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.