Story-I Limited (ASX:SRY) delivered a less impressive 13.08% ROE over the past year, compared to the 13.50% 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 SRY’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SRY’s returns. See our latest analysis for SRY
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if SRY invests A$1 in the form of equity, it will generate A$0.13 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 SRY, which is 8.70%. Some of SRY’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for SRY which is reassuring. 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. The other component, asset turnover, illustrates how much revenue SRY can make from its 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 SRY’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check SRY’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 24.31%, meaning SRY still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? Although SRY’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity, which is encouraging. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.