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With an ROE of 4.15%, Realia Business SA. (BME:RLIA) outpaced its own industry which delivered a less exciting 3.12% over the past year. On the surface, this looks fantastic since we know that RLIA has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable RLIA’s ROE is. See our latest analysis for Realia Business
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Realia Business’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.04 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
Returns are usually compared to costs to measure the efficiency of capital. Realia Business’s cost of equity is 17.63%. This means Realia Business’s returns actually do not cover its own cost of equity, with a discrepancy of -13.48%. 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 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 Realia Business’s 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 Realia Business’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 73.10%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Realia Business exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.