FG. Europe S.A.’s (ATSE:FGE) most recent return on equity was a substandard 5.20% relative to its industry performance of 7.94% over the past year. Though FGE’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on FGE’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FGE’s returns. Check out our latest analysis for F.G. Europe
Breaking down Return on Equity
Return on Equity (ROE) weighs F.G. Europe’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. F.G. Europe’s cost of equity is 15.00%. Since F.G. Europe’s return does not cover its cost, with a difference of -9.80%, this means its current use of equity is not efficient and not sustainable. Very simply, F.G. Europe pays more 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. Asset turnover reveals how much revenue can be generated from F.G. Europe’s 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 F.G. Europe’s debt-to-equity level. Currently the debt-to-equity ratio stands at a high 168.60%, which means its below-average ROE is already being driven by significant debt levels.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. F.G. Europe’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.