IKloukinas-I.Lappas S.A.’s (ATSE:KLM) most recent return on equity was a substandard 1.01% relative to its industry performance of 5.40% over the past year. Though KLM’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 KLM’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of KLM’s returns. View our latest analysis for I.Kloukinas-I.Lappas
Breaking down Return on Equity
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 €1 in the form of equity, it will generate €0.01 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 I.Kloukinas-I.Lappas, which is 11.94%. Given a discrepancy of -10.93% between return and cost, this indicated that I.Kloukinas-I.Lappas may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue I.Kloukinas-I.Lappas 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 financial leverage can artificially inflate ROE, we need to look at how much debt I.Kloukinas-I.Lappas currently has. At 27.62%, I.Kloukinas-I.Lappas’s debt-to-equity ratio appears low and indicates that I.Kloukinas-I.Lappas still has room to increase leverage and grow its profits.