Paragon Care Limited (ASX:PGC) delivered a less impressive 11.14% ROE over the past year, compared to the 11.27% return generated by its industry. Though PGC’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 PGC’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PGC’s returns. Check out our latest analysis for Paragon Care
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Paragon Care’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.11 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
Returns are usually compared to costs to measure the efficiency of capital. Paragon Care’s cost of equity is 8.55%. While Paragon Care’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Paragon Care which is encouraging. ROE can be dissected into three distinct 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 shows how much revenue Paragon Care can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Paragon Care currently has. At 61.38%, Paragon Care’s debt-to-equity ratio appears sensible and indicates its 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. Although Paragon Care’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Paragon Care’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.