Starvest plc (AIM:SVE) delivered an ROE of 18.88% over the past 12 months, which is an impressive feat relative to its industry average of 13.55% during the same period. But what is more interesting is whether SVE can sustain this above-average ratio. A measure of sustainable returns is SVE’s financial leverage. If SVE borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. View our latest analysis for Starvest
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs SVE’s profit against the level of its shareholders’ equity. For example, if SVE invests £1 in the form of equity, it will generate £0.19 in earnings from this. Investors seeking to maximise their return in the Asset Management and Custody Banks industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of SVE’s equity capital deployed. Its cost of equity is 9.36%. Given a positive discrepancy of 9.52% between return and cost, this indicates that SVE pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient SVE is with its cost management. The other component, asset turnover, illustrates how much revenue SVE can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SVE’s capital structure is. We can determine if SVE’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at SVE’s debt-to-equity ratio. Currently the ratio stands at 2.53%, which is very low. This means SVE has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
Why is ROE called the mother of all ratios
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. SVE’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Though there are other vital factors we need to consider before we conclude whether or not SVE’s returns are sustainable. I recommend you see our latest FREE analysis report to find out more about other measures!
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