EVRAZ plc (LSE:EVR) delivered an ROE of 37.46% over the past 12 months, which is an impressive feat relative to its industry average of 15.23% during the same period. But what is more interesting is whether EVR can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, EVR can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for EVRAZ
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of EVRAZ’s profit relative to its shareholders’ equity. An ROE of 37.46% implies £0.37 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 Steel sector by investing in 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
Returns are usually compared to costs to measure the efficiency of capital. EVRAZ’s cost of equity is 12.99%. Since EVRAZ’s return covers its cost in excess of 24.47%, its use of equity capital is efficient and likely to be sustainable. Simply put, EVRAZ pays less for its capital than what it generates in return. 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
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 EVRAZ’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. 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 EVRAZ’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at more than 2.5 times, which is very high. This means EVRAZ’s above-average ROE is being driven by its significant debt levels and its ability to grow profit hinges on a significant debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. EVRAZ’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For EVRAZ, I’ve put together three essential aspects you should further research:
- 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 EVRAZ 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 EVRAZ is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of EVRAZ? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!