Westag & Getalit AG (DB:WUG) delivered a less impressive 5.99% ROE over the past year, compared to the 12.67% return generated by its industry. WUG’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on WUG’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of WUG’s returns. Let me show you what I mean by this. See our latest analysis for Westag & Getalit
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 5.99% 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. Westag & Getalit’s cost of equity is 8.23%. Given a discrepancy of -2.24% between return and cost, this indicated that Westag & Getalit may be paying more for its capital than what it’s generating 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. Asset turnover reveals how much revenue can be generated from Westag & Getalit’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 Westag & Getalit currently has. Currently, Westag & Getalit has no debt which means its returns are driven purely by equity capital. This could explain why Westag & Getalit’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.