Steel & Tube Holdings Limited (NZSE:STU) delivered 11.5% ROE over the past year, compared to 18.5% generated by its industry. While an inferior ROE points towards a relatively inefficient performance, knowing the nuts and bolts of ROE calculation may change that perspective. See our latest analysis for STU
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 estimate 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 STU’s cost of equity at 13.75%, compared to its ROE of 11.5%.
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.
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.Steel & Tube Holdings’s ROA over the past 12 months stood at 5.5% versus the industry’s 5.91%. 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. STU’s debt to equity ratio currently stands at 0.66. 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
On the surface, ROE appears to be a simple profitability ratio indicating the return an investor should expect. However, for a sound investment consideration, it should still appear good when a company’s debt profile, profit-revenue trend, and leverage are considered. What do the analysts think about Steel & Tube Holdings’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
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