This article is intended for those of you who are at the beginning of your investing journey and want to better understand how you can grow your money by investing in Entertainment One Ltd (LON:ETO).
With an ROE of 11.08%, Entertainment One Ltd (LON:ETO) returned in-line to its own industry which delivered 9.95% over the past year. But what is more interesting is whether ETO can sustain this level of return. A measure of sustainable returns is ETO’s financial leverage. If ETO borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. Check out our latest analysis for Entertainment One
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Entertainment One’s profit relative to its shareholders’ equity. An ROE of 11.08% implies £0.11 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 Movies and Entertainment 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
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 Entertainment One, which is 8.28%. This means Entertainment One returns enough to cover its own cost of equity, with a buffer of 2.80%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
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 reveals how much revenue can be generated from Entertainment One’s 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 Entertainment One’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 78.24%, which is sensible and indicates Entertainment One has not taken on too much leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a large 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. Entertainment One’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For Entertainment One, there are three pertinent aspects you should further examine:
- 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 Entertainment One 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 Entertainment One is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Entertainment One? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!