Novavis Spólka Akcyjna (WSE:NVV) delivered a less impressive 3.76% ROE over the past year, compared to the 6.93% return generated by its industry. 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 NVV’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of NVV’s returns. Check out our latest analysis for Novavis Spólka Akcyjna
What you must know about ROE
Return on Equity (ROE) weighs Novavis Spólka Akcyjna’s profit against the level of its shareholders’ equity. An ROE of 3.76% implies PLN0.04 returned on every PLN1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Novavis Spólka Akcyjna’s equity capital deployed. Its cost of equity is 8.67%. Given a discrepancy of -4.91% between return and cost, this indicated that Novavis Spólka Akcyjna 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. Asset turnover reveals how much revenue can be generated from Novavis Spólka Akcyjna’s 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 Novavis Spólka Akcyjna currently has. At 6.23%, Novavis Spólka Akcyjna’s debt-to-equity ratio appears low and indicates that Novavis Spólka Akcyjna still has room to increase leverage and grow its profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Novavis Spólka Akcyjna’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.