Can K2 Internet SA. (WSE:K2I) Continue To Outperform Its Industry?

K2 Internet SA. (WSE:K2I) delivered an ROE of 12.65% over the past 12 months, which is relatively in-line with its industry average of 10.85% during the same period. However, whether this ROE is actually impressive depends on if it can be maintained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for K2 Internet

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 12.65% implies PLN0.13 returned on every PLN1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Internet Software and Services 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 K2 Internet has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Returns are usually compared to costs to measure the efficiency of capital. K2 Internet’s cost of equity is 8.67%. Since K2 Internet’s return covers its cost in excess of 3.99%, its use of equity capital is efficient and likely to be sustainable. Simply put, K2 Internet pays less for its capital than what it generates 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:

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue K2 Internet 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 K2 Internet’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is 19.41%, which is sensible and indicates K2 Internet has not taken on too much leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a large debt burden.

Next Steps:

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. K2 Internet exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. 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 K2 Internet, I've put together three important factors you should look at:

• 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 K2 Internet 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 K2 Internet is currently mispriced by the market.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of K2 Internet? 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.