Energy One Limited’s (ASX:EOL) most recent return on equity was a substandard 5.52% relative to its industry performance of 16.67% over the past year. Though EOL’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on EOL’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of EOL’s returns. Check out our latest analysis for Energy One
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Energy One’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. 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 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 Energy One, which is 9.92%. This means Energy One’s returns actually do not cover its own cost of equity, with a discrepancy of -4.40%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be split up into three useful 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 shows how much revenue Energy One can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Energy One currently has. At 31.91%, Energy One’s debt-to-equity ratio appears low and indicates that Energy One still has room to increase leverage and grow its profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Energy One’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Energy One’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.