K3 Capital Group Plc (AIM:K3C) outperformed the Research and Consulting Services industry on the basis of its ROE – producing a higher 55.87% relative to the peer average of 13.92% over the past 12 months. While the impressive ratio tells us that K3C has made significant profits from little equity capital, ROE doesn’t tell us if K3C has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether K3C’s ROE is actually sustainable. Check out our latest analysis for K3 Capital Group
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of K3 Capital Group’s equity capital deployed. Its cost of equity is 8.30%. This means K3 Capital Group returns enough to cover its own cost of equity, with a buffer of 47.58%. This sustainable practice implies that the company pays less 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
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 K3 Capital Group’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt K3 Capital Group currently has. Currently, K3 Capital Group has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. K3 Capital Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.