JUST EAT plc (LSE:JE.) delivered a less impressive 10.32% ROE over the past year, compared to the 17.55% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into JE.'s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of JE.'s returns. Check out our latest analysis for JUST EAT
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 10.32% implies £0.1 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
ROE is measured against cost of equity in order to determine the efficiency of JE.’s equity capital deployed. Its cost of equity is 8.43%. JE.’s ROE exceeds its cost by 1.89%, which is a big tick. Some of its peers with higher ROE may face a cost which exceeds returns, which is unsustainable and far less desirable than JE.’s case of positive discrepancy. 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. Asset turnover shows how much revenue JE. 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 JE. currently has. Currently the debt-to-equity ratio stands at a low 0.11%, which means JE. still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? Although JE.’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity, which is encouraging. Since ROE is not inflated by excessive debt, it might be a good time to add more of JE. 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%.