BBGI Sicav SA’s (LSE:BBGI) most recent return on equity was a substandard 10.53% relative to its industry performance of 13.55% over the past year. Though BBGI’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 BBGI’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BBGI’s returns. View our latest analysis for BBGI Sicav
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 £0.11 in earnings from this. 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 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 BBGI Sicav, which is 9.39%. While BBGI Sicav’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for BBGI Sicav which is encouraging. 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 shows how much revenue BBGI Sicav can generate with its current 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 ROE can be artificially increased through excessive borrowing, we should check BBGI Sicav’s historic debt-to-equity ratio. Currently, BBGI Sicav has no debt which means its returns are driven purely by equity capital. This could explain why BBGI Sicav’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.