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This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Sky plc (LON:SKY) outperformed the Cable and Satellite industry on the basis of its ROE – producing a higher 20.3% relative to the peer average of 7.3% over the past 12 months. Superficially, this looks great since we know that SKY has generated big profits with little equity capital; however, ROE doesn’t tell us how much SKY has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether SKY’s ROE is actually sustainable.
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What you must know about ROE
Return on Equity (ROE) weighs Sky’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.20 in earnings from this. 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 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 Sky, which is 8.3%. Given a positive discrepancy of 12.0% between return and cost, this indicates that Sky 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 reveals how much revenue can be generated from Sky’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Sky’s debt-to-equity level. At 204%, Sky’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
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ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Sky’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Sky’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.