Petróleo Brasileiro SA - Petrobras (NYSE:PBR.A) generated a below-average return on equity of 3.23% in the past 12 months, while its industry returned 9.06%. PBR.A's results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on PBR.A’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PBR.A's returns. Check out our latest analysis for Petróleo Brasileiro - Petrobras
What you must know about ROE
Return on Equity (ROE) is a measure of PBR.A’s profit relative to its shareholders’ equity. It essentially shows how much PBR.A can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Integrated Oil and Gas sector by investing in 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.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of PBR.A’s equity capital deployed. Its cost of equity is 14.12%. This means PBR.A’s returns actually do not cover its own cost of equity, with a discrepancy of -10.89%. 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:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue PBR.A can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if PBR.A’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at PBR.A’s debt-to-equity ratio. The most recent ratio is 135.87%, which is relatively proportionate and indicates PBR.A has not taken on extreme leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a massive debt burden.
ROE - It’s not just another ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency by looking at both its income statement and balance sheet. PBR.A’s below-industry ROE is disappointing, furthermore, its returns were not even high 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 Petróleo Brasileiro - Petrobras, I've compiled three fundamental factors 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. Valuation: What is PBR.A 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 PBR.A is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of PBR.A? 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 has no position in any of the companies mentioned. This article is general in nature. 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.
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