This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Centamin plc (LON:CEY) outperformed the gold industry on the basis of its ROE – producing a higher 17.32% relative to the peer average of 10.94% over the past 12 months. Though, the impressiveness of CEY’s ROE is contingent on whether this industry-beating level can be sustained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. View out our latest analysis for Centamin
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Centamin’s profit against the level of its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.17 in earnings from this. Investors seeking to maximise their return in the Gold industry may want to choose 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 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 Centamin, which is 8.58%. Given a positive discrepancy of 8.73% between return and cost, this indicates that Centamin pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Centamin 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 assess whether Centamin is fuelling ROE by excessively raising debt. Ideally, Centamin should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently, Centamin has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Centamin’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Centamin, I’ve compiled three key 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 Centamin 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 Centamin is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Centamin? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!