Spark Infrastructure Group’s (ASX:SKI) most recent return on equity was a substandard 3.76% relative to its industry performance of 5.36% 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 SKI’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SKI’s returns. See our latest analysis for SKI

Breaking down Return on Equity

Return on Equity (ROE) weighs SKI’s profit against the level of its shareholders’ equity. An ROE of 3.76% implies A$0.04 returned on every A$1 invested. 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

ROE is measured against cost of equity in order to determine the efficiency of SKI’s equity capital deployed. Its cost of equity is 8.55%. This means SKI’s returns actually do not cover its own cost of equity, with a discrepancy of -4.79%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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 SKI’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check SKI’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 50.40%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.

What this means for you:

Are you a shareholder? SKI exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as SKI still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.

Are you a potential investor? If SKI has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Spark Infrastructure Group to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.