I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
With an ROE of 42.00%, Distribuidora Internacional de Alimentación SA (BME:DIA) outpaced its own industry which delivered a less exciting 11.31% over the past year. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. A measure of sustainable returns is DIA’s financial leverage. If DIA 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.
Breaking down Return on Equity
Return on Equity (ROE) weighs Distribuidora Internacional de Alimentación’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.42 in earnings from this. Investors seeking to maximise their return in the Hypermarkets and Super Centers 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Distribuidora Internacional de Alimentación, which is 9.99%. Since Distribuidora Internacional de Alimentación’s return covers its cost in excess of 32.01%, its use of equity capital is efficient and likely to be sustainable. Simply put, Distribuidora Internacional de Alimentación pays less for its capital than what it generates 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Distribuidora Internacional de Alimentación can generate with its current 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. We can assess whether Distribuidora Internacional de Alimentación is fuelling ROE by excessively raising debt. Ideally, Distribuidora Internacional de Alimentación should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at more than 2.5 times, which is very high. This means Distribuidora Internacional de Alimentación’s above-average ROE is being driven by its significant debt levels and its ability to grow profit hinges on a significant debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Distribuidora Internacional de Alimentación’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Distribuidora Internacional de Alimentación, I’ve put together three fundamental 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 Distribuidora Internacional de Alimentación 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 Distribuidora Internacional de Alimentación is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Distribuidora Internacional de Alimentación? 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 firstname.lastname@example.org.