What is Behind Faes Farma SA’s (BME:FAE) Superior ROE?

This analysis is intended to introduce important early concepts to people who are starting to invest and looking to gauge the potential return on investment in Faes Farma SA (BME:FAE).

With an ROE of 14.60%, Faes Farma SA (BME:FAE) outpaced its own industry which delivered a less exciting 11.33% over the past year. But what is more interesting is whether FAE can sustain this above-average ratio. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for Faes Farma

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Faes Farma’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Pharmaceuticals sector by investing in 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

ROE is measured against cost of equity in order to determine the efficiency of Faes Farma’s equity capital deployed. Its cost of equity is 8.26%. This means Faes Farma returns enough to cover its own cost of equity, with a buffer of 6.34%. This sustainable practice implies that the company pays less 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:

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

BME:FAE Last Perf June 30th 18
BME:FAE Last Perf June 30th 18

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 Faes Farma can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can determine if Faes Farma’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 Faes Farma’s debt-to-equity ratio. The most recent ratio is 14.76%, which is sensible and indicates Faes Farma has not taken on too much leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a large debt burden.

BME:FAE Historical Debt June 30th 18
BME:FAE Historical Debt June 30th 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Faes Farma’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.

For Faes Farma, there are three fundamental factors you should further examine:

  1. 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.
  2. Valuation: What is Faes Farma 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 Faes Farma is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Faes Farma? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!