NEFAZ Publicly Traded Company (MISX:NFAZ) delivered an ROE of 21.69% over the past 12 months, which is an impressive feat relative to its industry average of 4.83% during the same period. On the surface, this looks fantastic since we know that NFAZ 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 NFAZ’s ROE is. See our latest analysis for NEFAZ Publicly Traded
What you must know about ROE
Return on Equity (ROE) weighs NEFAZ Publicly Traded’s profit against the level of its shareholders’ equity. For example, if the company invests RUB1 in the form of equity, it will generate RUB0.22 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 NEFAZ Publicly Traded, which is 22.95%. Since NEFAZ Publicly Traded’s return does not cover its cost, with a difference of -1.26%, this means its current use of equity is not efficient and not sustainable. Very simply, NEFAZ Publicly Traded pays more for its capital than what it generates in return. ROE can be broken down into three different 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 NEFAZ Publicly Traded’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 NEFAZ Publicly Traded’s debt-to-equity level. At over 2.5 times, NEFAZ Publicly Traded’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. NEFAZ Publicly Traded’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.