Somero Enterprises Inc (AIM:SOM) outperformed the Construction Machinery and Heavy Trucks industry on the basis of its ROE – producing a higher 41.42% relative to the peer average of 11.00% over the past 12 months. While the impressive ratio tells us that SOM has made significant profits from little equity capital, ROE doesn’t tell us if SOM has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether SOM’s ROE is actually sustainable. Check out our latest analysis for Somero Enterprises
Breaking down Return on Equity
Return on Equity (ROE) weighs Somero Enterprises’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.41 in earnings from this. 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 Somero Enterprises, which is 8.30%. This means Somero Enterprises returns enough to cover its own cost of equity, with a buffer of 33.12%. This sustainable practice implies that the company 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Somero Enterprises can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Somero Enterprises currently has. Currently, Somero Enterprises has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.