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.
With an ROE of 10.8%, Koninklijke VolkerWessels NV (AMS:KVW) outpaced its own industry which delivered a less exciting 9.0% over the past year. While the impressive ratio tells us that KVW has made significant profits from little equity capital, ROE doesn’t tell us if KVW has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether KVW’s ROE is actually sustainable.
Check out our latest analysis for Koninklijke VolkerWessels
What you must know about ROE
Return on Equity (ROE) is a measure of Koninklijke VolkerWessels’s profit relative to its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.11 in earnings from this. 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 Koninklijke VolkerWessels’s equity capital deployed. Its cost of equity is 11.1%. Given a discrepancy of -0.3% between return and cost, this indicated that Koninklijke VolkerWessels may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Koninklijke VolkerWessels can generate with its current 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 financial leverage can artificially inflate ROE, we need to look at how much debt Koninklijke VolkerWessels currently has. At 32.7%, Koninklijke VolkerWessels’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.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Koninklijke VolkerWessels’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.