PPK Group Limited’s (ASX:PPK) most recent return on equity was a substandard 3.36% relative to its industry performance of 10.83% over the past year. PPK’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on PPK’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PPK’s returns. Check out our latest analysis for PPK Group
Breaking down Return on Equity
Return on Equity (ROE) weighs PPK Group’s profit against the level of 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 PPK Group’s equity capital deployed. Its cost of equity is 10.28%. Given a discrepancy of -6.92% between return and cost, this indicated that PPK Group may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue PPK Group can make from its 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 PPK Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 7.86%, which means PPK Group still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? PPK’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means PPK still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.