With an ROE of 6.43%, Magseis ASA (OB:MSEIS) outpaced its own industry which delivered a less exciting 6.34% over the past year. While the impressive ratio tells us that MSEIS has made significant profits from little equity capital, ROE doesn’t tell us if MSEIS has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of MSEIS’s ROE. Check out our latest analysis for Magseis
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Magseis’s profit relative to its shareholders’ equity. For example, if the company invests NOK1 in the form of equity, it will generate NOK0.06 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. Magseis’s cost of equity is 8.77%. This means Magseis’s returns actually do not cover its own cost of equity, with a discrepancy of -2.34%. 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 split up into three useful 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. The other component, asset turnover, illustrates how much revenue Magseis 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 Magseis currently has. The debt-to-equity ratio currently stands at a low 2.15%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge 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. Magseis’s above-industry ROE is noteworthy, but it was not high enough to cover its own 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.