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West Wits Mining Limited’s (ASX:WWI) most recent return on equity was a substandard 2.44% relative to its industry performance of 11.24% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into WWI’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of WWI’s returns. View our latest analysis for West Wits Mining
What you must know about ROE
Return on Equity (ROE) weighs West Wits Mining’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.02 in earnings from this. 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 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 West Wits Mining, which is 9.50%. Since West Wits Mining’s return does not cover its cost, with a difference of -7.06%, this means its current use of equity is not efficient and not sustainable. Very simply, West Wits Mining pays more for its capital than what it generates 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. The other component, asset turnover, illustrates how much revenue West Wits Mining can make from its 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 inflated by excessive debt, we need to examine West Wits Mining’s debt-to-equity level. Currently, West Wits Mining has no debt which means its returns are driven purely by equity capital. This could explain why West Wits Mining’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.