This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
GEA Group Aktiengesellschaft (FRA:G1A) delivered a less impressive 7.73% ROE over the past year, compared to the 11.59% return generated by its industry. G1A’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on G1A’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of G1A’s returns. Let me show you what I mean by this.
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Industrial Machinery industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. GEA Group’s cost of equity is 9.03%. Given a discrepancy of -1.30% between return and cost, this indicated that GEA Group may be paying more for its capital than what it’s generating in return. ROE can be broken down into three different 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from GEA Group’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if GEA Group’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 GEA Group’s debt-to-equity ratio. Currently the ratio stands at 16.19%, which is very low. This means GEA Group has not taken on leverage, which could explain its below-average ROE. GEA Group still has headroom to take on more leverage in order to grow its returns.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. GEA Group exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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 GEA Group, there are three important aspects you should further research:
- 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 GEA Group 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 GEA Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of GEA Group? 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 pass 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 firstname.lastname@example.org.