This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between company’s fundamentals and stock market performance.
Cauldron Energy Limited (ASX:CXU) delivered a less impressive 4.0% ROE over the past year, compared to the 10.3% return generated by its industry. Though CXU’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 CXU’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CXU’s returns. Let me show you what I mean by this.
Check out our latest analysis for Cauldron Energy
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Cauldron Energy’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.040 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
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 Cauldron Energy, which is 9.3%. Since Cauldron Energy’s return does not cover its cost, with a difference of -5.4%, this means its current use of equity is not efficient and not sustainable. Very simply, Cauldron Energy pays more for its capital than what it generates in return. ROE can be split up into three useful 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 Cauldron Energy can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Cauldron Energy’s debt-to-equity level. Currently, Cauldron Energy has no debt which means its returns are driven purely by equity capital. This could explain why Cauldron Energy’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.