Will K&K Herbal Poland SA. (WSE:KKH) Continue To Underperform Its Industry?

K&K Herbal Poland SA.’s (WSE:KKH) most recent return on equity was a substandard 0.032% relative to its industry performance of 13.75% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into KKH's past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of KKH's returns. Let me show you what I mean by this. See our latest analysis for K&K Herbal Poland

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. For example, if the company invests PLN1 in the form of equity, it will generate PLN0 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Distributors sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.

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 K&K Herbal Poland, which is 8.67%. This means K&K Herbal Poland’s returns actually do not cover its own cost of equity, with a discrepancy of -8.63%. 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 dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

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 K&K Herbal Poland can make from its 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 K&K Herbal Poland is fuelling ROE by excessively raising debt. Ideally, K&K Herbal Poland should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently K&K Herbal Poland has virtually no debt, which means its returns are predominantly driven by equity capital. This could explain why K&K Herbal Poland's' ROE is lower than its industry peers, most of which may have some degree of debt in its business.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. K&K Herbal Poland’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. 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 K&K Herbal Poland, there are three pertinent aspects you should further research:

• 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. Future Earnings: How does K&K Herbal Poland'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.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of K&K Herbal Poland? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com

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.