Prime Media Group Limited (ASX:PRT) delivered an ROE of 65.67% over the past 12 months, which is an impressive feat relative to its industry average of 9.62% during the same period. On the surface, this looks fantastic since we know that PRT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of PRT’s ROE. See our latest analysis for Prime Media Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Prime Media Group’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.66 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 Prime Media Group, which is 17.24%. Since Prime Media Group’s return covers its cost in excess of 48.43%, its use of equity capital is efficient and likely to be sustainable. Simply put, Prime Media Group pays less for its capital than what it generates 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
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 Prime Media Group’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Prime Media Group’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 64.79%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? PRT exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.