Wellcom Group Limited’s (ASX:WLL) 17.2% ROE over the past year fell short of the performance averaged by the industry, which delivered 19.04% ROE in the same period. On the surface, while Wellcom Group appears to have underperformed, there’s more to any company’s ROE than just the final figure. Check out our latest analysis for Wellcom Group
Peeling the layers of ROE – trisecting a company’s profitability
ROE is one of the most popular ratios to calculate the profitability of a company. The ratio is arrived by putting net earnings in the numerator and shareholders’ equity in the denominator. Any ROE north of 20%, implying 20 cents return on every dollar invested, is favourable for any investor. But investors seek multiple assets to diversify risk and an industry-specific comparison makes more sense to achieve the goal of choosing the best among a given lot.
Return on Equity = Net Profit ÷ Shareholders Equity
For a company to create value for its shareholders, it must generate an ROE higher than the cost of equity. Unlike debt-holders, there is no predefined return for equity investors. However, an expected return to account for market risk can be arrived at using the Capital Asset Pricing Model. For WLL, it stands at 8.43% versus its ROE of 17.2%.
ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward. The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. Wellcom Group’s ROA stood at 11.6% in the past year, compared to the industry’s 7.84%.
The last but not the least is the financial leverage. It’s an important ratio as a company can hide its poor operating and asset-use efficiency by increasing leverage. Thus, along with ROE, we should look at the Return on capital, which reflects earnings as a percentage of overall capital employed, including debt. For WLL, ROC stood at 24% versus the industry’s 10.73%.
ROE – More than just a profitability ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency both through the income statement and the balance sheet, along with telling you how just changing the capital structure of the company can impact perceived return. What are the analysts thinking about Wellcom Group’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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