Evrofarma SA (ATSE:EVROF) generated a below-average return on equity of 4.41% in the past 12 months, while its industry returned 5.92%. 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 EVROF’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of EVROF’s returns. View our latest analysis for Evrofarma
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Evrofarma’s profit relative to its shareholders’ equity. An ROE of 4.41% implies €0.04 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 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 Evrofarma, which is 10.88%. Given a discrepancy of -6.46% between return and cost, this indicated that Evrofarma may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Evrofarma’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 Evrofarma’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a high 191.72%, 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. Evrofarma’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 Evrofarma’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.