Meggitt PLC (LSE:MGGT) generated a below-average return on equity of 12.45% in the past 12 months, while its industry returned 14.16%. 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 MGGT’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of MGGT’s returns. Check out our latest analysis for Meggitt
Breaking down Return on Equity
Return on Equity (ROE) weighs Meggitt’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.12 in earnings from this. 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 Meggitt, which is 8.30%. While Meggitt’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 Meggitt which is encouraging. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Meggitt can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Meggitt currently has. Currently the debt-to-equity ratio stands at a low 49.37%, which means Meggitt still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? Even though MGGT returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of MGGT to your portfolio if your personal research is confirming what the ROE is telling you. 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%.