EML Payments Limited’s (ASX:EML) most recent return on equity was a substandard 0.01% relative to its industry performance of 15.40% over the past year. Though EML’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 EML’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of EML’s returns. Let me show you what I mean by this. View our latest analysis for EML Payments
Breaking down Return on Equity
Return on Equity (ROE) is a measure of EML’s profit relative to its shareholders’ equity. It essentially shows how much EML 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 measured against cost of equity in order to determine the efficiency of EML’s equity capital deployed. Its cost of equity is 8.55%. This means EML’s returns actually do not cover its own cost of equity, with a discrepancy of -8.54%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient EML is with its cost management. Asset turnover shows how much revenue EML can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check EML’s historic debt-to-equity ratio. Currently, EML has no debt which means its returns are driven purely by equity capital. This could explain why EML’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
What this means for you:
Are you a shareholder? EML exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as EML still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.