Foley Family Wines Limited (NZSE:FFW) generated a below-average return on equity of 4.09% in the past 12 months, while its industry returned 11.30%. Though FFW’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 FFW’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of FFW’s returns. View our latest analysis for Foley Family Wines

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

Return on Equity (ROE) is a measure of Foley Family Wines’s profit relative to its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.04 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

Returns are usually compared to costs to measure the efficiency of capital. Foley Family Wines’s cost of equity is 8.55%. Since Foley Family Wines’s return does not cover its cost, with a difference of -4.46%, this means its current use of equity is not efficient and not sustainable. Very simply, Foley Family Wines pays more for its capital than what it generates in return. ROE can be split up into three useful 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 Foley Family Wines’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 financial leverage can artificially inflate ROE, we need to look at how much debt Foley Family Wines currently has. The debt-to-equity ratio currently stands at a low 22.74%, meaning Foley Family Wines still has headroom to borrow debt to increase profits.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Foley Family Wines’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.