GAME Digital plc (LSE:GMD) generated a below-average return on equity of 1.79% in the past 12 months, while its industry returned 16.11%. Though GMD'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 GMD's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GMD's returns. See our latest analysis for GMD
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 GMD invests £1 in the form of equity, it will generate £0.02 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 GMD’s equity capital deployed. Its cost of equity is 8.30%. Since GMD’s return does not cover its cost, with a difference of -6.51%, this means its current use of equity is not efficient and not sustainable. Very simply, GMD 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 GMD is with its cost management. Asset turnover reveals how much revenue can be generated from GMD’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check GMD’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 2.94%, meaning GMD still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? GMD exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means GMD still has room to improve shareholder returns by raising debt to fund new investments. If you're looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.