Is Erbud SA.'s (WSE:ERB) ROE Of 8.37% Sustainable?

Erbud SA. (WSE:ERB) performed in-line with its construction and engineering industry on the basis of its ROE – producing a return of8.37% relative to the peer average of 7.70% over the past 12 months. 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, ERB 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. Check out our latest analysis for Erbud

Peeling the layers of ROE – trisecting a company’s profitability

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Construction and Engineering 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.

Returns are usually compared to costs to measure the efficiency of capital. Erbud’s cost of equity is 8.67%. Given a discrepancy of -0.29% between return and cost, this indicated that Erbud may be paying more for its capital than what it’s generating 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:

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Erbud can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether Erbud is fuelling ROE by excessively raising debt. Ideally, Erbud 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 41.07%, meaning Erbud has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Erbud exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.

For Erbud, I've compiled three key 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 Erbud 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 Erbud is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Erbud? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.