With an ROE of 13.92%, PLT energia Sp.A. (BIT:PLTE) outpaced its own industry which delivered a less exciting 6.94% over the past year. While the impressive ratio tells us that PLTE has made significant profits from little equity capital, ROE doesn’t tell us if PLTE has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether PLTE’s ROE is actually sustainable. Check out our latest analysis for energia
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of energia’s profit relative to its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.14 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
Returns are usually compared to costs to measure the efficiency of capital. energia’s cost of equity is 14.33%. Since energia’s return does not cover its cost, with a difference of -0.40%, this means its current use of equity is not efficient and not sustainable. Very simply, energia 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 energia’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 artificially increased through excessive borrowing, we should check energia’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. energia’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of energia’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.