Lefroy Exploration Limited’s (ASX:LEX) most recent return on equity was a substandard 7.05% relative to its industry performance of 10.60% 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 LEX’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of LEX’s returns. View our latest analysis for Lefroy Exploration
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Lefroy Exploration’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$0.07 in earnings from this. 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. Lefroy Exploration’s cost of equity is 9.67%. Since Lefroy Exploration’s return does not cover its cost, with a difference of -2.62%, this means its current use of equity is not efficient and not sustainable. Very simply, Lefroy Exploration 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Lefroy Exploration can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Lefroy Exploration currently has. Currently, Lefroy Exploration has no debt which means its returns are driven purely by equity capital. This could explain why Lefroy Exploration’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.