ES-System Spólka Akcyjna (WSE:ESS) performed in line with its building products industry on the basis of its ROE – producing a return of4.74% relative to the peer average of 5.43% over the past 12 months. But what is more interesting is whether ESS can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ESS’s returns. View our latest analysis for ES-System Spólka Akcyjna
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of ES-System Spólka Akcyjna’s profit relative to its shareholders’ equity. An ROE of 4.74% implies PLN0.05 returned on every PLN1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Building Products sector by investing in 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. ES-System Spólka Akcyjna’s cost of equity is 8.67%. This means ES-System Spólka Akcyjna’s returns actually do not cover its own cost of equity, with a discrepancy of -3.92%. This isn’t sustainable as it implies, very simply, that the company pays more 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue ES-System Spólka Akcyjna 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. 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 ES-System Spólka Akcyjna’s debt-to-equity ratio to examine sustainability of its returns. Currently ES-System Spólka Akcyjna has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why ES-System Spólka Akcyjna’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. ES-System Spólka Akcyjna exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of ES-System Spólka Akcyjna’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 ES-System Spólka Akcyjna, there are three essential factors you should look at:
- 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.
- Future Earnings: How does ES-System Spólka Akcyjna’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ES-System Spólka Akcyjna? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!