With an ROE of 14.42%, Pact Group Holdings Ltd (ASX:PGH) outpaced its own industry which delivered a less exciting 11.95% over the past year. While the impressive ratio tells us that PGH has made significant profits from little equity capital, ROE doesn’t tell us if PGH has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of PGH’s ROE. View our latest analysis for Pact Group Holdings
Peeling the layers of ROE – trisecting a company’s profitability
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 A$1 in the form of equity, it will generate A$0.14 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. Pact Group Holdings’s cost of equity is 9.64%. Since Pact Group Holdings’s return covers its cost in excess of 4.78%, its use of equity capital is efficient and likely to be sustainable. Simply put, Pact Group Holdings pays less 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
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 Pact Group Holdings’s 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 Pact Group Holdings currently has. At 96.96%, Pact Group Holdings’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Pact Group Holdings’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.