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With an ROE of 49.93%, AB Inter RAO Lietuva (WSE:IRL) outpaced its own industry which delivered a less exciting 8.21% over the past year. On the surface, this looks fantastic since we know that IRL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether IRL’s ROE is actually sustainable. View our latest analysis for AB Inter RAO Lietuva
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs AB Inter RAO Lietuva’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 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 AB Inter RAO Lietuva, which is 8.67%. Since AB Inter RAO Lietuva’s return covers its cost in excess of 41.26%, its use of equity capital is efficient and likely to be sustainable. Simply put, AB Inter RAO Lietuva pays less for its capital than what it generates 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue AB Inter RAO Lietuva can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine AB Inter RAO Lietuva’s debt-to-equity level. At 83.10%, AB Inter RAO Lietuva’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. AB Inter RAO Lietuva’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.