ZOO Digital Group plc (AIM:ZOO) delivered a less impressive 2.69% ROE over the past year, compared to the 11.51% 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 ZOO’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ZOO’s returns. Let me show you what I mean by this. See our latest analysis for ZOO Digital Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs ZOO Digital Group’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.03 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 measured against cost of equity in order to determine the efficiency of ZOO Digital Group’s equity capital deployed. Its cost of equity is 8.30%. Since ZOO Digital Group’s return does not cover its cost, with a difference of -5.61%, this means its current use of equity is not efficient and not sustainable. Very simply, ZOO Digital 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue ZOO Digital Group 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 the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check ZOO Digital Group’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 62.87%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.