Petropavlovsk PLC’s (LSE:POG) most recent return on equity was a substandard 7.16% relative to its industry performance of 11.12% over the past year. Though POG’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on POG’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of POG’s returns. Check out our latest analysis for Petropavlovsk
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Gold sector by choosing 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. Petropavlovsk’s cost of equity is 18.51%. Since Petropavlovsk’s return does not cover its cost, with a difference of -11.35%, this means its current use of equity is not efficient and not sustainable. Very simply, Petropavlovsk pays more 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 Petropavlovsk’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether Petropavlovsk is fuelling ROE by excessively raising debt. Ideally, Petropavlovsk should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a balanced 103.00%, meaning Petropavlovsk has not taken on excessively disproportionate debt to drive its returns. The company is able to produce profit growth without a substantial 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. Petropavlovsk’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Petropavlovsk’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Petropavlovsk, I’ve compiled three important 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.
- Valuation: What is Petropavlovsk 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 Petropavlovsk is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Petropavlovsk? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!