STM Group Plc (AIM:STM) delivered an ROE of 11.85% over the past 12 months, which is relatively in-line with its industry average of 13.64% during the same period. But what is more interesting is whether STM can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of STM’s returns. Let me show you what I mean by this. View our latest analysis for STM Group
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 11.85% implies £0.12 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 Asset Management and Custody Banks 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 STM’s equity capital deployed. Its cost of equity is 10.29%. While STM’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for STM which is encouraging. ROE can be split up into three useful 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 STM is with its cost management. Asset turnover reveals how much revenue can be generated from STM’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if STM’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 STM’s debt-to-equity ratio. The ratio currently stands at a sensible 11.23%, meaning STM 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 – It’s not just another ratio
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. While STM exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Also, 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 STM Group, there are three pertinent aspects 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 STM 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 STM is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of STM? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!