War and Peace Media group (MISX:MGVM) generated a below-average return on equity of 7.09% in the past 12 months, while its industry returned 10.90%. Though MGVM’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 MGVM’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of MGVM’s returns. Let me show you what I mean by this. Check out our latest analysis for War and Peace Media group

Peeling the layers of ROE – trisecting a company’s profitability

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests RUB1 in the form of equity, it will generate RUB0.07 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

Returns are usually compared to costs to measure the efficiency of capital. War and Peace Media group’s cost of equity is 8.71%. Since War and Peace Media group’s return does not cover its cost, with a difference of -1.63%, this means its current use of equity is not efficient and not sustainable. Very simply, War and Peace Media group 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue War and Peace Media group can make from its 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 War and Peace Media group currently has. Currently, War and Peace Media group has no debt which means its returns are driven purely by equity capital. This could explain why War and Peace Media group’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.