Enalyzer A/S’s (CPSE:ENALYZ) most recent return on equity was a substandard 9.93% relative to its industry performance of 12.42% over the past year. 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 ENALYZ’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ENALYZ’s returns. Check out our latest analysis for Enalyzer
What you must know about ROE
Return on Equity (ROE) is a measure of Enalyzer’s profit relative to its shareholders’ equity. For example, if the company invests DKK1 in the form of equity, it will generate DKK0.1 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Enalyzer’s cost of equity is 9.47%. While Enalyzer’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 Enalyzer which is encouraging. ROE can be split up into three useful 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. The other component, asset turnover, illustrates how much revenue Enalyzer 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 artificially increased through excessive borrowing, we should check Enalyzer’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 3.53%, which means Enalyzer still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. While Enalyzer exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Also, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.