Yahoo Finance How GKN plc (LON:GKN) Delivered A Better ROE Than Its Industry
This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between GKN plc (LON:GKN)’s return fundamentals and stock market performance.
GKN plc (LON:GKN) outperformed the Auto Parts and Equipment industry on the basis of its ROE – producing a higher 19.73% relative to the peer average of 13.93% over the past 12 months. On the surface, this looks fantastic since we know that GKN has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of GKN’s ROE. See our latest analysis for GKN
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of GKN’s profit relative to its shareholders’ equity. For example, if the company invests £1 in the form of equity, it will generate £0.20 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of GKN’s equity capital deployed. Its cost of equity is 10.36%. This means GKN returns enough to cover its own cost of equity, with a buffer of 9.37%. This sustainable practice implies that the company 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:
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. Asset turnover shows how much revenue GKN 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. Since ROE can be artificially increased through excessive borrowing, we should check GKN’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 50.97%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. GKN’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For GKN, I’ve put together three key aspects 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.
Valuation: What is GKN 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 GKN is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of GKN? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.
