Mediterra SA.’s (ATSE:MSHOP) most recent return on equity was a substandard 3.02% relative to its industry performance of 13.33% over the past year. MSHOP’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 MSHOP’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of MSHOP’s returns. See our latest analysis for Mediterra
What you must know about ROE
Return on Equity (ROE) weighs Mediterra’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
Returns are usually compared to costs to measure the efficiency of capital. Mediterra’s cost of equity is 8.85%. Since Mediterra’s return does not cover its cost, with a difference of -5.83%, this means its current use of equity is not efficient and not sustainable. Very simply, Mediterra pays more 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
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 Mediterra’s 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 Mediterra’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 5.33%, meaning Mediterra still has headroom to borrow debt to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Mediterra’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.