Burberry Group plc (LSE:BRBY) generated a below-average return on equity of 20.86% in the past 12 months, while its industry returned 25.16%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into BRBY’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BRBY’s returns. See our latest analysis for Burberry Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Burberry Group’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.21 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 measured against cost of equity in order to determine the efficiency of Burberry Group’s equity capital deployed. Its cost of equity is 8.30%. While Burberry Group’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Burberry Group which is encouraging. 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. The other component, asset turnover, illustrates how much revenue Burberry Group can make from its 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 inflated by excessive debt, we need to examine Burberry Group’s debt-to-equity level. At 1.59%, Burberry Group’s debt-to-equity ratio appears low and indicates that Burberry Group still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? Although BRBY’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity, which is encouraging. 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%.