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With an ROE of 15.58%, Renault SA (ENXTPA:RNO) outpaced its own industry which delivered a less exciting 15.01% over the past year. Superficially, this looks great since we know that RNO has generated big profits with little equity capital; however, ROE doesn’t tell us how much RNO has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of RNO’s ROE. See our latest analysis for Renault
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. For example, if the company invests €1 in the form of equity, it will generate €0.16 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 Renault, which is 15.34%. This means Renault returns enough to cover its own cost of equity, with a buffer of 0.24%. This sustainable practice implies that the company pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Renault’s 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 Renault currently has. Currently the debt-to-equity ratio stands at a high 151.27%, which means its above-average ROE is driven by significant debt levels.
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ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Renault’s above-industry ROE is encouraging, and is also in excess of its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.