Autins Group plc’s (AIM:AUTG) most recent return on equity was a substandard 2.53% relative to its industry performance of 13.44% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into AUTG’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AUTG’s returns. View our latest analysis for Autins Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Autins Group’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.03 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Auto Parts and Equipment 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. Autins Group’s cost of equity is 11.34%. Since Autins Group’s return does not cover its cost, with a difference of -8.81%, this means its current use of equity is not efficient and not sustainable. Very simply, Autins Group 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
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 Autins Group can make from its 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 Autins Group’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 Autins Group’s debt-to-equity ratio. The ratio currently stands at a sensible 22.99%, meaning Autins Group has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Autins Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. 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 Autins Group, I’ve put together three key 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.
- Future Earnings: How does Autins Group’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 Autins Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!