Public Joint Stock Company Kurgan Generation Company (MISX:KGKC) generated a below-average return on equity of 7.85% in the past 12 months, while its industry returned 12.25%. Though KGKC’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on KGKC’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of KGKC’s returns. See our latest analysis for Kurgan Generation
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Kurgan Generation’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Kurgan Generation, which is 13.41%. Since Kurgan Generation’s return does not cover its cost, with a difference of -5.56%, this means its current use of equity is not efficient and not sustainable. Very simply, Kurgan Generation 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Kurgan Generation’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Kurgan Generation’s debt-to-equity level. At 32.35%, Kurgan Generation’s debt-to-equity ratio appears low and indicates that Kurgan Generation still has room to increase leverage and grow its profits.