Iberpapel Gestión SA.’s (BME:IBG) most recent return on equity was a substandard 9.95% relative to its industry performance of 12.61% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into IBG’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of IBG’s returns. View our latest analysis for Iberpapel Gestión
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Iberpapel Gestión’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Iberpapel Gestión’s equity capital deployed. Its cost of equity is 10.20%. Since Iberpapel Gestión’s return does not cover its cost, with a difference of -0.25%, this means its current use of equity is not efficient and not sustainable. Very simply, Iberpapel Gestión pays more 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Iberpapel Gestión’s 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 artificially increased through excessive borrowing, we should check Iberpapel Gestión’s historic debt-to-equity ratio. At 32.48%, Iberpapel Gestión’s debt-to-equity ratio appears low and indicates that Iberpapel Gestión still has room to increase leverage and grow its profits.