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Refresco Group NV.’s (ENXTAM:RFRG) most recent return on equity was a substandard 9.61% relative to its industry performance of 9.96% over the past year. Though RFRG’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 RFRG’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RFRG’s returns. View our latest analysis for Refresco Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Refresco Group’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. 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 Refresco Group, which is 8.14%. Some of Refresco Group’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Refresco Group which is reassuring. 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. The other component, asset turnover, illustrates how much revenue Refresco Group 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 ROE can be inflated by excessive debt, we need to examine Refresco Group’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 134.09%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.