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Marks and Spencer Group plc’s (LSE:MKS) most recent return on equity was a substandard 6.40% relative to its industry performance of 13.33% over the past year. 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 MKS’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of MKS’s returns. Check out our latest analysis for Marks and Spencer Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Marks and Spencer Group’s profit relative to its shareholders’ equity. An ROE of 6.40% implies £0.06 returned on every £1 invested. 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. Marks and Spencer Group’s cost of equity is 8.30%. Since Marks and Spencer Group’s return does not cover its cost, with a difference of -1.90%, this means its current use of equity is not efficient and not sustainable. Very simply, Marks and Spencer Group 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Marks and Spencer Group can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Marks and Spencer Group currently has. Currently the debt-to-equity ratio stands at a reasonable 76.08%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Marks and Spencer Group’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.