Petróleo Brasileiro SA. – Petrobras’s (NYSE:PBR) most recent return on equity was a substandard 0.97% relative to its industry performance of 11.54% over the past year. Though PBR’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on PBR’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PBR’s returns. See our latest analysis for Petróleo Brasileiro – Petrobras

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Petróleo Brasileiro – Petrobras’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

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 Petróleo Brasileiro – Petrobras, which is 12.73%. Since Petróleo Brasileiro – Petrobras’s return does not cover its cost, with a difference of -11.76%, this means its current use of equity is not efficient and not sustainable. Very simply, Petróleo Brasileiro – Petrobras pays more 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 reveals how much revenue can be generated from Petróleo Brasileiro – Petrobras’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Petróleo Brasileiro – Petrobras’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 122.76%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Petróleo Brasileiro – Petrobras’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. Although ROE can be a useful metric, it is only a small part of diligent research.

For Petróleo Brasileiro – Petrobras, there are three relevant factors you should further examine:

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 Petróleo Brasileiro – Petrobras 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 Petróleo Brasileiro – Petrobras is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Petróleo Brasileiro – Petrobras? 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.