The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Cancom SE (ETR:COK) delivered a less impressive 11.1% ROE over the past year, compared to the 17.8% return generated by its industry. COK’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on COK’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of COK’s returns. Let me show you what I mean by this.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Cancom’s profit against the level of its shareholders’ equity. An ROE of 11.1% implies €0.11 returned on every €1 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
Returns are usually compared to costs to measure the efficiency of capital. Cancom’s cost of equity is 8.1%. While Cancom’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Cancom which is encouraging. 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. The other component, asset turnover, illustrates how much revenue Cancom can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Cancom currently has. At 1.8%, Cancom’s debt-to-equity ratio appears low and indicates that Cancom still has room to increase leverage and grow its profits.
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. Although Cancom’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.