In This Article:
Persimmon Plc (LSE:PSN) outperformed the Homebuilding industry on the basis of its ROE – producing a higher 24.58% relative to the peer average of 15.91% over the past 12 months. While the impressive ratio tells us that PSN has made significant profits from little equity capital, ROE doesn’t tell us if PSN has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable PSN’s ROE is. View our latest analysis for Persimmon
Breaking down Return on Equity
Return on Equity (ROE) weighs Persimmon’s profit against the level of its shareholders’ equity. An ROE of 24.58% implies £0.25 returned on every £1 invested. 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 Persimmon, which is 8.30%. Since Persimmon’s return covers its cost in excess of 16.28%, its use of equity capital is efficient and likely to be sustainable. Simply put, Persimmon pays less 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. Asset turnover reveals how much revenue can be generated from Persimmon’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 Persimmon’s debt-to-equity level. Currently, Persimmon has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
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. Persimmon’s ROE is impressive relative to the industry average and also covers its 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.