The Environmental Group Limited (ASX:EGL) outperformed the Industrial Machinery industry on the basis of its ROE – producing a higher 12.89% relative to the peer average of 10.83% over the past 12 months. Superficially, this looks great since we know that EGL has generated big profits with little equity capital; however, ROE doesn’t tell us how much EGL has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable EGL’s ROE is. View our latest analysis for Environmental Group
What you must know about ROE
Return on Equity (ROE) is a measure of EGL’s profit relative to its shareholders’ equity. It essentially shows how much EGL can generate in earnings given the amount of equity it has raised. 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 EGL, which is 8.55%. Since EGL’s return covers its cost in excess of 4.34%, its use of equity capital is efficient and likely to be sustainable. Simply put, EGL 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from EGL’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt EGL currently has. At 7.43%, EGL’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.
What this means for you:
Are you a shareholder? EGL exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of EGL 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%.