Public Joint Stock Company Kovrov Mechanical Plant (MISX:KMEZ) delivered a less impressive 4.83% ROE over the past year, compared to the 10.98% return generated by its industry. Though KMEZ’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 KMEZ’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of KMEZ’s returns. Let me show you what I mean by this. View our latest analysis for Kovrov Mechanical Plant
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 4.83% implies RUB0.05 returned on every RUB1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Kovrov Mechanical Plant’s cost of equity is 13.41%. Since Kovrov Mechanical Plant’s return does not cover its cost, with a difference of -8.58%, this means its current use of equity is not efficient and not sustainable. Very simply, Kovrov Mechanical Plant 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
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 Kovrov Mechanical Plant’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 Kovrov Mechanical Plant currently has. Currently, Kovrov Mechanical Plant has no debt which means its returns are driven purely by equity capital. This could explain why Kovrov Mechanical Plant’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.