In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Southern Cross Media Group Limited’s (ASX:SXL) most recent return on equity was a substandard 0.2% relative to its industry performance of 9.3% over the past year. SXL’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 SXL’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SXL’s returns.
Check out our latest analysis for Southern Cross Media Group
What you must know about ROE
Return on Equity (ROE) is a measure of Southern Cross Media Group’s profit relative to its shareholders’ equity. An ROE of 0.2% implies A$0.0024 returned on every A$1 invested. 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. Southern Cross Media Group’s cost of equity is 8.6%. This means Southern Cross Media Group’s returns actually do not cover its own cost of equity, with a discrepancy of -8.3%. This isn’t sustainable as it implies, very simply, that the company pays more 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Southern Cross Media Group can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Southern Cross Media Group currently has. The debt-to-equity ratio currently stands at a sensible 60.4%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.