With an ROE of 12.61%, Panostaja Oyj (HLSE:PNA1V) outpaced its own industry which delivered a less exciting 12.31% over the past year. On the surface, this looks fantastic since we know that PNA1V 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 PNA1V’s ROE is. View our latest analysis for Panostaja Oyj
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 12.61% implies €0.13 returned on every €1 invested. 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
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 Panostaja Oyj, which is 17.60%. Since Panostaja Oyj’s return does not cover its cost, with a difference of -4.99%, this means its current use of equity is not efficient and not sustainable. Very simply, Panostaja Oyj pays more for its capital than what it generates in return. 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
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 Panostaja Oyj can make from its 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 ROE can be artificially increased through excessive borrowing, we should check Panostaja Oyj’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 100.71%, 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. Panostaja Oyj’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Although ROE can be a useful metric, it is only a small part of diligent research.