With an ROE of 58.79%, Forterra plc (LSE:FORT) outpaced its own industry which delivered a less exciting 12.16% over the past year. While the impressive ratio tells us that FORT has made significant profits from little equity capital, ROE doesn’t tell us if FORT has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable FORT’s ROE is. Check out our latest analysis for Forterra
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of FORT’s profit relative to its shareholders’ equity. For example, if FORT invests £1 in the form of equity, it will generate £0.59 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 FORT, which is 8.30%. Given a positive discrepancy of 50.49% between return and cost, this indicates that FORT pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 FORT is with its cost management. The other component, asset turnover, illustrates how much revenue FORT can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable FORT’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine FORT’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 146.15%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? FORT’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.