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With An ROE Of 0.2%, Has Diamond Estates Wines & Spirits Inc’s (CVE:DWS) Management Done Well?

This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.

Diamond Estates Wines & Spirits Inc (CVE:DWS) delivered a less impressive 0.2% ROE over the past year, compared to the 2.3% return generated by its industry. Though DWS’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 DWS’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of DWS’s returns. Let me show you what I mean by this.

See our latest analysis for Diamond Estates Wines & Spirits

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

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 CA$1 in the form of equity, it will generate CA$0.0017 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.

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Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of Diamond Estates Wines & Spirits’s equity capital deployed. Its cost of equity is 8.5%. This means Diamond Estates Wines & Spirits’s returns actually do not cover its own cost of equity, with a discrepancy of -8.3%. 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:

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

TSXV:DWS Last Perf August 29th 18
TSXV:DWS Last Perf August 29th 18

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Diamond Estates Wines & Spirits’s 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 inflated by excessive debt, we need to examine Diamond Estates Wines & Spirits’s debt-to-equity level. At 122%, Diamond Estates Wines & Spirits’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.

TSXV:DWS Historical Debt August 29th 18
TSXV:DWS Historical Debt August 29th 18

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. Diamond Estates Wines & Spirits exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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 Diamond Estates Wines & Spirits, 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. Future Earnings: How does Diamond Estates Wines & Spirits’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 Diamond Estates Wines & Spirits? 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 past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.