This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Sixt Leasing SE (ETR:LNSX) generated a below-average return on equity of 9.7% in the past 12 months, while its industry returned 16.0%. LNSX’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 LNSX’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LNSX’s returns.
Check out our latest analysis for Sixt Leasing
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Sixt Leasing’s profit against the level of its shareholders’ equity. An ROE of 9.7% implies €0.097 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 Sixt Leasing’s equity capital deployed. Its cost of equity is 19.5%. This means Sixt Leasing’s returns actually do not cover its own cost of equity, with a discrepancy of -9.8%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Sixt Leasing can make from its 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 Sixt Leasing’s debt-to-equity level. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Sixt Leasing’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.