Geke SA. (ATSE:PRESD) generated a below-average return on equity of 4.92% in the past 12 months, while its industry returned 10.85%. PRESD’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 PRESD’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PRESD’s returns. Check out our latest analysis for Geke
What you must know about ROE
Return on Equity (ROE) is a measure of Geke’s profit relative to its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.05 in earnings from this. Investors seeking to maximise their return in the Hotels, Resorts and Cruise Lines 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
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 Geke, which is 9.58%. Since Geke’s return does not cover its cost, with a difference of -4.65%, this means its current use of equity is not efficient and not sustainable. Very simply, Geke 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:
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. The other component, asset turnover, illustrates how much revenue Geke can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. 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 Geke’s debt-to-equity ratio to examine sustainability of its returns. Currently, Geke has no debt which means its returns are driven purely by equity capital. This could explain why Geke’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
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. Geke’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 Geke’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For Geke, I’ve put together three essential factors 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 Geke 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 Geke is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Geke? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!