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.
Liberty Shoes Limited’s (NSE:LIBERTSHOE) most recent return on equity was a substandard 4.6% relative to its industry performance of 7.2% over the past year. LIBERTSHOE’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on LIBERTSHOE’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of LIBERTSHOE’s returns. Let me show you what I mean by this.
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Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Liberty Shoes’s cost of equity is 13.5%. This means Liberty Shoes’s returns actually do not cover its own cost of equity, with a discrepancy of -8.9%. This isn’t sustainable as it implies, very simply, that the company 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 Liberty Shoes 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 ROE can be artificially increased through excessive borrowing, we should check Liberty Shoes’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 69.0%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.