Microgen plc (LSE:MCGN) delivered a 15.2% ROE over the past year; however, the figure is only significant when we compare it to returns from assets with similar risk profile: the industry average, which stood at 15.88% in the same time period. View our latest analysis for Microgen
Breaking down ROE — the mother of all ratios
ROE is simply the percentage of past year earnings against the book value of shareholders’ equity, which is the sum of retained earnings and capital raised through equity offerings.Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.
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 MCGN’s cost of equity at 9.07%, compared to its ROE of 15.2%. 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 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. Microgen’s ROA stood at 6.6% in the past year, compared to the industry’s 23.16%.
We can assess whether MCGN is fuelling ROE by excessively raising debt or it has a balanced capital structure by looking at the historic debt-equity trend of the company. While Microgen’s debt to equity ratio currently stands at 0.24, investors should assess how it has changed over the past few years. To account for leverage, we should look at MCGN’s Return on capital, which stood at 15% in the past year versus industry’s 141.94%. ROC is earnings as a percentage of overall employed capital compared to just equity as in the case of ROE.
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 Microgen’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
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