Zespól Elektrocieplowni Wroclawskich KOGENERACJA SA. (WSE:KGN) generated a below-average return on equity of 8.78% in the past 12 months, while its industry returned 9.89%. KGN’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 KGN’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of KGN’s returns. See our latest analysis for Zespól Elektrocieplowni Wroclawskich KOGENERACJA
What you must know about ROE
Return on Equity (ROE) weighs Zespól Elektrocieplowni Wroclawskich KOGENERACJA’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
ROE is measured against cost of equity in order to determine the efficiency of Zespól Elektrocieplowni Wroclawskich KOGENERACJA’s equity capital deployed. Its cost of equity is 8.67%. Some of Zespól Elektrocieplowni Wroclawskich KOGENERACJA’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Zespól Elektrocieplowni Wroclawskich KOGENERACJA which is reassuring. 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 Zespól Elektrocieplowni Wroclawskich KOGENERACJA can make from its 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 inflated by excessive debt, we need to examine Zespól Elektrocieplowni Wroclawskich KOGENERACJA’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 3.33%, meaning Zespól Elektrocieplowni Wroclawskich KOGENERACJA still has headroom to borrow debt to increase profits.