Future PLC’s (LSE:FUTR) most recent return on equity was a substandard 2.61% relative to its industry performance of 9.42% over the past year. Though FUTR’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 FUTR’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FUTR’s returns. View our latest analysis for Future
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.03 in earnings from this. If investors diversify their portfolio by industry, they may want to maximise their return in the Publishing 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. Future’s cost of equity is 8.30%. Since Future’s return does not cover its cost, with a difference of -5.69%, this means its current use of equity is not efficient and not sustainable. Very simply, Future 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Future can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Future is fuelling ROE by excessively raising debt. Ideally, Future 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 sensible 32.95%, meaning Future has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden and still has headroom to grow returns to industry average.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Future’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 Future’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 Future, there are three relevant aspects 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 Future 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 Future is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Future? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!