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 Southern Gold Limited (ASX:SAU)’s return fundamentals and stock market performance.
With an ROE of 14.38%, Southern Gold Limited (ASX:SAU) outpaced its own industry which delivered a less exciting 11.89% over the past year. Superficially, this looks great since we know that SAU has generated big profits with little equity capital; however, ROE doesn’t tell us how much SAU has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SAU’s ROE. View out our latest analysis for Southern Gold
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 14.38% implies A$0.14 returned on every A$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 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 Southern Gold, which is 9.72%. This means Southern Gold returns enough to cover its own cost of equity, with a buffer of 4.66%. This sustainable practice implies that the company pays less 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. The other component, asset turnover, illustrates how much revenue Southern Gold can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Southern Gold’s debt-to-equity level. Currently, Southern Gold has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.