I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Highlight Event and Entertainment AG (VTX:HLEE) delivered a less impressive 1.1% ROE over the past year, compared to the 18.5% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into HLEE’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HLEE’s returns.
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests CHF1 in the form of equity, it will generate CHF0.011 in earnings from this. Investors seeking to maximise their return in the Advertising 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
Returns are usually compared to costs to measure the efficiency of capital. Highlight Event and Entertainment’s cost of equity is 11.5%. Since Highlight Event and Entertainment’s return does not cover its cost, with a difference of -10.5%, this means its current use of equity is not efficient and not sustainable. Very simply, Highlight Event and Entertainment pays more for its capital than what it generates in return. 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 the business is with its cost management. The other component, asset turnover, illustrates how much revenue Highlight Event and Entertainment can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Highlight Event and Entertainment’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 16.9%, which is sensible and indicates Highlight Event and Entertainment has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and Highlight Event and Entertainment still has room to increase leverage and grow future returns.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Highlight Event and Entertainment’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Highlight Event and Entertainment, there are three fundamental factors you should look at:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Highlight Event and Entertainment worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Highlight Event and Entertainment is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Highlight Event and Entertainment? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.