Fletcher Building Limited’s (NZSE:FBU) ROE of 13% over the past year, compared to its industry’s 18.18%, indicates that investors would have been better off choosing the broader industry in terms of returns generated on their committed capital. However, there is more to a company’s ROE than just the blunt-final-figure. That’s why I always advise investors to analyze the ROE at a much lower level and consider the numerous factors that affect a company’s past performance. View our latest analysis for Fletcher Building
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.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 FBU’s cost of equity at 8.65%, compared to its ROE of 13%.
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. Fletcher Building’s ROA stood at 5.9% in the past year, compared to the industry’s 6.1%.
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 FBU, ROC stood at 10% versus the industry’s -1.22%.
ROE – More than just a profitability 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 Fletcher Building’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
If you are not interested in FBU anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.