Probiotec Limited’s (ASX:PBP) 5.6% ROE over the past year fell short of the performance averaged by the industry, which delivered 44.21% ROE in the same period. On the surface, while Probiotec appears to have underperformed, there’s more to any company’s ROE than just the final figure. See our latest analysis for PBP
What you must know about ROE
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity. While an ROE ratio of more than 15% would draw any investor’s attention, historically, established companies in the developed countries have delivered an ROE between 10% and 12%.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE above the cost of equity anticipate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs PBP’s cost of equity at 8.77%, compared to its ROE of 5.6%.
When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
Dupont Formula
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A reflection of how net profit margin has affected ROE in the past can be seen in the trend of income and revenue. An investor can gauge a fair project of how it’s going to play out in the future by looking at the analysts’ forecasts in the years ahead. While the change in a company’s asset turnover ratio is important in assessing the quality of ROE, an equally important aspect is its comparison to the industry average. Probiotec generated an ROA of 3.1% versus the industry’s 12.46%. For an industry, ROA, which is earnings as a percentage of assets, is a sound representation of asset turnover.
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. PBP’s debt to equity ratio currently stands at 0.17. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
ROE – It’s not just another ratio
While ROE can be calculated through a very simple calculation, investors should look at various ratios by breaking it down and how each of them affects the return to understand the strengths and weakness of a company. It’s one of the few ratios which stitches together performance metrics from the income statement and the balance sheet. What are the analysts’ projection of Probiotec’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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