With an ROE of 8.54%, Petropavlovsk PLC (LSE:POG) returned in-line to its own industry which delivered 9.77% over the past year. But what is more interesting is whether POG can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of POG’s returns. View our latest analysis for Petropavlovsk
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Petropavlovsk’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.09 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Gold sector by investing in the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Petropavlovsk has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Petropavlovsk’s equity capital deployed. Its cost of equity is 18.51%. Given a discrepancy of -9.97% between return and cost, this indicated that Petropavlovsk may be paying more for its capital than what it’s generating 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. Asset turnover shows how much revenue Petropavlovsk can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 Petropavlovsk’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a balanced 102.96%, 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.
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. Petropavlovsk exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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, there are three relevant 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 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.
3. 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!