The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and looking to gauge the potential return on investment in Smurfit Kappa Group plc (ISE:SK3).
Smurfit Kappa Group plc (ISE:SK3) delivered an ROE of 15.91% over the past 12 months, which is relatively in-line with its industry average of 14.62% during the same period. However, whether this ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, SK3 can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. View out our latest analysis for Smurfit Kappa Group
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 15.91% implies €0.16 returned on every €1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Paper Packaging industry may want to choose the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Smurfit Kappa Group has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Smurfit Kappa Group’s equity capital deployed. Its cost of equity is 11.51%. This means Smurfit Kappa Group returns enough to cover its own cost of equity, with a buffer of 4.40%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be broken down into three different 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. Asset turnover shows how much revenue Smurfit Kappa Group can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Smurfit Kappa Group’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 Smurfit Kappa Group’s debt-to-equity ratio. The most recent ratio is 126.14%, which is relatively proportionate and indicates Smurfit Kappa Group has not taken on extreme leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a massive debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Smurfit Kappa Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Smurfit Kappa Group, I’ve compiled three pertinent factors 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 Smurfit Kappa 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 Smurfit Kappa Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Smurfit Kappa 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!