I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Merlin Entertainments plc (LON:MERL) outperformed the Leisure Facilities industry on the basis of its ROE – producing a higher 13.2% relative to the peer average of 10.5% over the past 12 months. While the impressive ratio tells us that MERL has made significant profits from little equity capital, ROE doesn’t tell us if MERL has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable MERL’s ROE is.
See our latest analysis for Merlin Entertainments
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Merlin Entertainments’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.13 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 Merlin Entertainments, which is 8.3%. Given a positive discrepancy of 4.9% between return and cost, this indicates that Merlin Entertainments pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
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 Merlin Entertainments can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Merlin Entertainments currently has. At 87.1%, Merlin Entertainments’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.