Severfield plc (LSE:SFR) delivered a less impressive 11.60% ROE over the past year, compared to the 14.30% return generated by its industry. SFR’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 SFR’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SFR’s returns. See our latest analysis for Severfield
What you must know about ROE
Return on Equity (ROE) is a measure of Severfield’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.12 in earnings from this. 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 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 Severfield, which is 8.30%. While Severfield’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Severfield which is encouraging. 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 Severfield’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 ROE can be artificially increased through excessive borrowing, we should check Severfield’s historic debt-to-equity ratio. Currently Severfield has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why Severfield’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.