This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
Befimmo SA (EBR:BEFB) generated a below-average return on equity of 5.5% in the past 12 months, while its industry returned 9.1%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into BEFB’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BEFB’s returns.
See our latest analysis for Befimmo
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Befimmo’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.055 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of Befimmo’s equity capital deployed. Its cost of equity is 8.2%. Since Befimmo’s return does not cover its cost, with a difference of -2.7%, this means its current use of equity is not efficient and not sustainable. Very simply, Befimmo 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 Befimmo’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 financial leverage can artificially inflate ROE, we need to look at how much debt Befimmo currently has. At 78.0%, Befimmo’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.