This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Passat Société Anonyme (EPA:PSAT) generated a below-average return on equity of 5.1% in the past 12 months, while its industry returned 11.1%. Though PSAT’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 PSAT’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PSAT’s returns. Let me show you what I mean by this.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Passat Société Anonyme’s profit against the level of its shareholders’ equity. An ROE of 5.1% implies €0.051 returned on every €1 invested. 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 Passat Société Anonyme, which is 10.9%. Given a discrepancy of -5.8% between return and cost, this indicated that Passat Société Anonyme may be paying more for its capital than what it’s generating 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 Passat Société Anonyme’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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Passat Société Anonyme currently has. Currently, Passat Société Anonyme has no debt which means its returns are driven purely by equity capital. This could explain why Passat Société Anonyme’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.