I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
UCW Limited (ASX:UCW) generated a below-average return on equity of 1.3% in the past 12 months, while its industry returned 16.3%. Though UCW’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on UCW’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of UCW’s returns.
See our latest analysis for UCW
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of UCW’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
ROE is measured against cost of equity in order to determine the efficiency of UCW’s equity capital deployed. Its cost of equity is 8.6%. Since UCW’s return does not cover its cost, with a difference of -7.2%, this means its current use of equity is not efficient and not sustainable. Very simply, UCW pays more for its capital than what it generates in return. 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
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 UCW can make from its 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 UCW currently has. Currently the debt-to-equity ratio stands at a low 10.4%, which means UCW still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. UCW’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, 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. Although ROE can be a useful metric, it is only a small part of diligent research.