Farm Pride Foods Limited (ASX:FRM) outperformed the Packaged Foods and Meats industry on the basis of its ROE – producing a higher 20.00% relative to the peer average of 14.85% over the past 12 months. While the impressive ratio tells us that FRM has made significant profits from little equity capital, ROE doesn’t tell us if FRM has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable FRM’s ROE is. Check out our latest analysis for Farm Pride Foods
What you must know about ROE
Return on Equity (ROE) is a measure of FRM’s profit relative to its shareholders’ equity. It essentially shows how much FRM 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 FRM’s equity capital deployed. Its cost of equity is 8.55%. Given a positive discrepancy of 11.45% between return and cost, this indicates that FRM pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 FRM can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine FRM’s debt-to-equity level. Currently FRM has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? FRM’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of FRM 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%.