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MGI Digital Technology Société Anonyme’s (EPA:ALMDG) most recent return on equity was a substandard 11.1% relative to its industry performance of 11.7% over the past year. Though ALMDG’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 ALMDG’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ALMDG’s returns.
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Breaking down Return on Equity
Return on Equity (ROE) is a measure of MGI Digital Technology Société Anonyme’s profit relative to 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 MGI Digital Technology Société Anonyme, which is 8.2%. While MGI Digital Technology Société Anonyme’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 MGI Digital Technology Société Anonyme which is encouraging. 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 MGI Digital Technology Société Anonyme’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 ROE can be artificially increased through excessive borrowing, we should check MGI Digital Technology Société Anonyme’s historic debt-to-equity ratio. At 19.1%, MGI Digital Technology Société Anonyme’s debt-to-equity ratio appears low and indicates that MGI Digital Technology Société Anonyme still has room to increase leverage and grow its profits.