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.
With an ROE of 7.14%, Acciona SA (BME:ANA) returned in-line to its own industry which delivered 8.70% over the past year. But what is more interesting is whether ANA can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ANA’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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Electric Utilities sector by choosing 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. Acciona’s cost of equity is 10.27%. Since Acciona’s return does not cover its cost, with a difference of -3.13%, this means its current use of equity is not efficient and not sustainable. Very simply, Acciona pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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. Asset turnover shows how much revenue Acciona can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Acciona is fuelling ROE by excessively raising debt. Ideally, Acciona should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a high 193.06%, meaning Acciona may have taken on a disproportionate level of debt which is driving its return. The company’s ability to produce profit growth may hinge on its big debt burden.
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. Acciona’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Acciona, there are three essential 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 Acciona 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 Acciona is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Acciona? 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.