This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Kid ASA (OB:KID) delivered an ROE of 14.36% over the past 12 months, which is an impressive feat relative to its industry average of 12.33% during the same period. Superficially, this looks great since we know that KID has generated big profits with little equity capital; however, ROE doesn’t tell us how much KID has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether KID’s ROE is actually sustainable.
View our latest analysis for Kid
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Kid’s profit relative to its shareholders’ equity. An ROE of 14.36% implies NOK0.14 returned on every NOK1 invested. 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 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 Kid, which is 9.73%. Given a positive discrepancy of 4.63% between return and cost, this indicates that Kid 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Kid can generate with its current 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 Kid’s debt-to-equity level. At 54.20%, Kid’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Kid exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.