With a ROE of 26.4%, Shoe Zone Plc (AIM:SHOE) could hardly match the performance of its industry, which averaged a ROE of 49%. However, a multitude of factors affect the ROE, which is unequivocally the most popular profitability ratio, and digging through them in detail is a must before arriving at any conclusion. See our latest analysis for SHOE
Breaking down ROE — the mother of all ratios
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 forecast 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 SHOE’s cost of equity at 8.62%, compared to its ROE of 26.4%.
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. Shoe Zone’s ROA over the past 12 months stood at 10.2% versus the industry’s 9.05%. Although an investor should look at multi-year asset turnover to assess its effect on the latest ROE, a quick comparison with the industry tells him whether it’s acceptable. We use ROA for the comparison as along with sales, used in asset turnover, earnings, used in ROA, are also comparable within the industry.
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. SHOE’s debt to equity ratio currently stands at 0. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
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 Shoe Zone’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
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