The Liberty SiriusXM Group (NASDAQ:LSXM.K) delivered a less impressive 10.66% ROE over the past year, compared to the 14.15% return generated by its industry. 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 LSXM.K’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of LSXM.K’s returns. Check out our latest analysis for Liberty SiriusXM Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Liberty SiriusXM Group’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 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 Liberty SiriusXM Group, which is 10.98%. Given a discrepancy of -0.32% between return and cost, this indicated that Liberty SiriusXM Group may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Liberty SiriusXM Group’s 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 Liberty SiriusXM Group currently has. Currently the debt-to-equity ratio stands at a low 48.41%, which means Liberty SiriusXM Group still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Liberty SiriusXM Group exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. Although ROE can be a useful metric, it is only a small part of diligent research.