Elve SA. (ATSE:ELBE) generated a below-average return on equity of 3.94% in the past 12 months, while its industry returned 9.91%. ELBE’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 ELBE’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ELBE’s returns. View our latest analysis for Elve
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Elve’s profit relative to its shareholders’ equity. An ROE of 3.94% implies €0.04 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 Apparel, Accessories and Luxury Goods 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 Elve, which is 8.85%. Given a discrepancy of -4.91% between return and cost, this indicated that Elve may be paying more for its capital than what it’s generating 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
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 Elve’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Elve’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Elve’s debt-to-equity ratio. Currently the ratio stands at 7.78%, which is very low. This means Elve has not taken on leverage, which could explain its below-average ROE. Elve still has headroom to take on more leverage in order to grow its returns.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Elve’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Elve, I’ve compiled three pertinent factors 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 Elve 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 Elve is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Elve? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!