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 begin learning the link between Praemium Limited (ASX:PPS)’s return fundamentals and stock market performance.
Praemium Limited’s (ASX:PPS) most recent return on equity was a substandard 4.52% relative to its industry performance of 9.10% over the past year. PPS’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on PPS’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PPS’s returns. Let me show you what I mean by this. Check out our latest analysis for Praemium
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.045 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
Returns are usually compared to costs to measure the efficiency of capital. Praemium’s cost of equity is 8.55%. Given a discrepancy of -4.04% between return and cost, this indicated that Praemium may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Praemium’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 Praemium’s debt-to-equity level. Currently, Praemium has no debt which means its returns are driven purely by equity capital. This could explain why Praemium’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.