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.
UNITEDLABELS Aktiengesellschaft (ETR:ULC) outperformed the Distributors industry on the basis of its ROE – producing a higher 34.7% relative to the peer average of 7.6% over the past 12 months. Superficially, this looks great since we know that ULC has generated big profits with little equity capital; however, ROE doesn’t tell us how much ULC has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ULC’s ROE is.
View our latest analysis for UNITEDLABELS
What you must know about ROE
Return on Equity (ROE) weighs UNITEDLABELS’s profit against the level of its shareholders’ equity. An ROE of 34.7% implies €0.35 returned on every €1 invested. 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 UNITEDLABELS, which is 10.4%. Since UNITEDLABELS’s return covers its cost in excess of 24.3%, its use of equity capital is efficient and likely to be sustainable. Simply put, UNITEDLABELS pays less for its capital than what it generates in return. 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 UNITEDLABELS’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 UNITEDLABELS’s historic debt-to-equity ratio. At over 2.5 times, UNITEDLABELS’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.