In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Prysmian SpA (BIT:PRY) outperformed the Electrical Components and Equipment industry on the basis of its ROE – producing a higher 11.2% relative to the peer average of 10.0% over the past 12 months. Superficially, this looks great since we know that PRY has generated big profits with little equity capital; however, ROE doesn’t tell us how much PRY has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether PRY’s ROE is actually sustainable.
Check out our latest analysis for Prysmian
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 the company invests €1 in the form of equity, it will generate €0.11 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. Prysmian’s cost of equity is 8.9%. This means Prysmian returns enough to cover its own cost of equity, with a buffer of 2.4%. This sustainable practice implies that the company pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Prysmian 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 Prysmian’s historic debt-to-equity ratio. At 82.6%, Prysmian’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large 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. Prysmian’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.