Begbies Traynor Group plc (AIM:BEG) generated a below-average return on equity of 0.12% in the past 12 months, while its industry returned 19.08%. 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 BEG’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BEG’s returns. Check out our latest analysis for Begbies Traynor Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Begbies Traynor Group’s profit relative to its shareholders’ equity. An ROE of 0.12% implies £0 returned on every £1 invested. 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. Begbies Traynor Group’s cost of equity is 8.30%. This means Begbies Traynor Group’s returns actually do not cover its own cost of equity, with a discrepancy of -8.18%. 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 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Begbies Traynor Group’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 inflated by excessive debt, we need to examine Begbies Traynor Group’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 26.57%, meaning Begbies Traynor Group still has headroom to borrow debt to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Begbies Traynor Group’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Begbies Traynor Group’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.