I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.

NZME Limited’s (NZSE:NZM) most recent return on equity was a substandard 6.0% relative to its industry performance of 11.4% over the past year. NZM’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 NZM’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NZM’s returns.

Check out our latest analysis for NZME

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs NZME’s profit against the level of its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.060 in earnings from this. 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

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 NZME, which is 9.5%. Since NZME’s return does not cover its cost, with a difference of -3.6%, this means its current use of equity is not efficient and not sustainable. Very simply, NZME 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. Asset turnover shows how much revenue NZME can generate with its current 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 inflated by excessive debt, we need to examine NZME’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 47.0%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. NZME exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of NZME’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For NZME, there are three pertinent aspects you should look at:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Valuation: What is NZME worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether NZME is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of NZME? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.