I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 19.4%, Wellcom Group Limited (ASX:WLL) outpaced its own industry which delivered a less exciting 13.1% over the past year. Superficially, this looks great since we know that WLL has generated big profits with little equity capital; however, ROE doesn’t tell us how much WLL has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WLL’s ROE.
View our latest analysis for Wellcom Group
What you must know about ROE
Return on Equity (ROE) is a measure of Wellcom Group’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of Wellcom Group’s equity capital deployed. Its cost of equity is 8.6%. Given a positive discrepancy of 10.8% between return and cost, this indicates that Wellcom Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Wellcom Group’s 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 ROE can be artificially increased through excessive borrowing, we should check Wellcom Group’s historic debt-to-equity ratio. At 16.9%, Wellcom Group’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Wellcom Group’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.