EBOS Group Limited (NZSE:EBO) delivered a less impressive 11.86% ROE over the past year, compared to the 14.69% return generated by its industry. EBO’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 EBO’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of EBO’s returns. Let me show you what I mean by this. See our latest analysis for EBOS Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs EBOS Group’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. 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 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 EBOS Group, which is 8.55%. While EBOS Group’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for EBOS Group which is encouraging. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue EBOS Group can generate with its current 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 artificially increased through excessive borrowing, we should check EBOS Group’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 52.02%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? Although EBO’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity, which is encouraging. Since ROE is not inflated by excessive debt, it might be a good time to add more of EBO to your portfolio if your personal research is confirming what the ROE is telling you. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.