Why Pets at Home Group Plc’s (LON:PETS) ROE Of 6.93% Does Not Tell The Whole Story

This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Pets at Home Group Plc (LON:PETS).

Pets at Home Group Plc’s (LON:PETS) most recent return on equity was a substandard 6.93% relative to its industry performance of 12.75% over the past year. PETS’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on PETS’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PETS’s returns. Let me show you what I mean by this. See our latest analysis for at Home Group

What you must know about ROE

Return on Equity (ROE) weighs at Home Group’s profit against the level of its shareholders’ equity. An ROE of 6.93% implies £0.069 returned on every £1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Specialty Stores industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. at Home Group’s cost of equity is 8.28%. Since at Home Group’s return does not cover its cost, with a difference of -1.35%, this means its current use of equity is not efficient and not sustainable. Very simply, at Home Group pays more 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:

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

LSE:PETS Last Perf June 30th 18
LSE:PETS Last Perf June 30th 18

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue at Home Group can make from its 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 at Home Group’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 21.47%, which is sensible and indicates at Home Group has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and at Home Group still has room to increase leverage and grow future returns.

LSE:PETS Historical Debt June 30th 18
LSE:PETS Historical Debt June 30th 18

Next Steps:

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. at Home Group’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of at Home Group’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 at Home Group, I’ve put together three key aspects you should look at:

  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 at Home Group 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 at Home Group is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of at Home Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!