Acciona SA. (BME:ANA) performed in line with its electric utilities industry on the basis of its ROE – producing a return of6.33% relative to the peer average of 8.72% over the past 12 months. But what is more interesting is whether ANA can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ANA’s returns. View our latest analysis for Acciona
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Acciona’s profit relative to its shareholders’ equity. An ROE of 6.33% implies €0.06 returned on every €1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Electric Utilities 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
Returns are usually compared to costs to measure the efficiency of capital. Acciona’s cost of equity is 10.94%. Since Acciona’s return does not cover its cost, with a difference of -4.61%, 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 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 Acciona can generate with its current 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. 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 Acciona’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 210.51%, which is relatively high. This means Acciona’s below-average ROE is already being driven by its high leverage and its ability to grow profit hinges on a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Acciona exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Acciona’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Acciona, I’ve put together three fundamental factors 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 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!