O2i Société Anonyme (ENXTPA:ALODI) generated a below-average return on equity of 2.59% in the past 12 months, while its industry returned 13.65%. ALODI’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 ALODI’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ALODI’s returns. Let me show you what I mean by this. Check out our latest analysis for O2i Société Anonyme
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. For example, if the company invests €1 in the form of equity, it will generate €0.03 in earnings from this. Investors seeking to maximise their return in the IT Consulting and Other Services 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 O2i Société Anonyme, which is 8.73%. Since O2i Société Anonyme’s return does not cover its cost, with a difference of -6.14%, this means its current use of equity is not efficient and not sustainable. Very simply, O2i Société Anonyme 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:
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 reveals how much revenue can be generated from O2i Société Anonyme’s 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 determine if O2i Société Anonyme’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 O2i Société Anonyme’s debt-to-equity ratio. Currently the ratio stands at 27.13%, which is very low. This means O2i Société Anonyme has not taken on leverage, which could explain its below-average ROE. O2i Société Anonyme still has headroom to take on more leverage in order to grow its returns.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. O2i Société Anonyme 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For O2i Société Anonyme, I’ve compiled three key 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.
- Future Earnings: How does O2i Société Anonyme’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of O2i Société Anonyme? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!