Kip McGrath Education Centres Limited’s (ASX:KME) most recent return on equity was a substandard 14.33% relative to its industry performance of 15.25% over the past year. Though KME’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 KME’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of KME’s returns. Check out our latest analysis for Kip McGrath Education Centres
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Kip McGrath Education Centres’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.14 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. Kip McGrath Education Centres’s cost of equity is 8.55%. Some of Kip McGrath Education Centres’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Kip McGrath Education Centres which is reassuring. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Kip McGrath Education Centres 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 inflated by excessive debt, we need to examine Kip McGrath Education Centres’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 6.53%, which means Kip McGrath Education Centres still has headroom to take on more leverage in order to increase profits.