I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Wm Morrison Supermarkets PLC (LON:MRW) delivered a less impressive 5.2% ROE over the past year, compared to the 9.0% 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 MRW’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of MRW’s returns. Let me show you what I mean by this.
Check out our latest analysis for Wm Morrison Supermarkets
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 5.2% implies £0.052 returned on every £1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 Wm Morrison Supermarkets, which is 8.3%. This means Wm Morrison Supermarkets’s returns actually do not cover its own cost of equity, with a discrepancy of -3.1%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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 shows how much revenue Wm Morrison Supermarkets can generate with its current 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 ROE can be inflated by excessive debt, we need to examine Wm Morrison Supermarkets’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 25.5%, meaning Wm Morrison Supermarkets still has headroom to borrow debt to increase profits.