Methven Limited (NZSE:MVN) delivered 12.3% ROE over the past year, compared to 32.83% 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. View our latest analysis for Methven
What you must know about ROE
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.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
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 MVN, it stands at 10.4% versus its ROE of 12.3%.
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 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 estimate of how it’s going to play out in the future by looking at the analysts’ forecasts in the years ahead.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. Methven’s ROA stood at 6.3% in the past year, compared to the industry’s 6.8%.
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. MVN’s debt to equity ratio currently stands at 0.5. 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 Methven’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
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