Rocca Spólka Akcyjna (WSE:RCA) performed in line with its construction materials industry on the basis of its ROE – producing a return of6.30% relative to the peer average of 9.04% over the past 12 months. But what is more interesting is whether RCA 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 RCA’s returns. Check out our latest analysis for Rocca Spólka Akcyjna
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Rocca Spólka Akcyjna’s profit against the level of its shareholders’ equity. An ROE of 6.30% implies PLN0.06 returned on every PLN1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Construction Materials sector by choosing 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 Rocca Spólka Akcyjna 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 Rocca Spólka Akcyjna’s equity capital deployed. Its cost of equity is 8.67%. Given a discrepancy of -2.37% between return and cost, this indicated that Rocca Spólka Akcyjna may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Rocca Spólka Akcyjna can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 Rocca Spólka Akcyjna’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 47.17%, which is very low. This means Rocca Spólka Akcyjna has not taken on leverage, which could explain its below-average ROE. Rocca Spólka Akcyjna still has headroom to take on more leverage in order to grow its returns.
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. Rocca Spólka Akcyjna exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Rocca Spólka Akcyjna, I’ve compiled three fundamental 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 Rocca 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 Rocca 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!