Grand Group Investment PLC (AIM:GIPO) delivered a less impressive 4.82% ROE over the past year, compared to the 12.78% return generated by its industry. GIPO'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 GIPO’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of GIPO's returns. Let me show you what I mean by this. View our latest analysis for Grand Group Investment
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of GIPO’s profit relative to its shareholders’ equity. An ROE of 4.82% implies £0.05 returned on every £1 invested. 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 measured against cost of equity in order to determine the efficiency of GIPO’s equity capital deployed. Its cost of equity is 9.32%. This means GIPO’s returns actually do not cover its own cost of equity, with a discrepancy of -4.50%. 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 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from GIPO’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable GIPO’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check GIPO’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 0.41%, meaning GIPO still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? GIPO’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means GIPO still has room to improve shareholder returns by raising debt to fund new investments.