This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
QSC AG (ETR:QSC) generated a below-average return on equity of 5.81% in the past 12 months, while its industry returned 12.74%. Though QSC’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on QSC’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of QSC’s returns. Let me show you what I mean by this.
See our latest analysis for QSC
What you must know about ROE
Return on Equity (ROE) weighs QSC’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.058 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 QSC, which is 8.11%. This means QSC’s returns actually do not cover its own cost of equity, with a discrepancy of -2.30%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from QSC’s 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 ROE can be inflated by excessive debt, we need to examine QSC’s debt-to-equity level. At 142.52%, QSC’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.