Enice Holding Company Limited (ASX:ENC) outperformed the Wireless Telecommunication Services industry on the basis of its ROE – producing a higher 19.17% relative to the peer average of 12.67% over the past 12 months. While the impressive ratio tells us that ENC has made significant profits from little equity capital, ROE doesn’t tell us if ENC has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ENC’s ROE. Check out our latest analysis for Enice Holding

Breaking down Return on Equity

Return on Equity (ROE) weighs Enice Holding’s profit against the level of its shareholders’ equity. An ROE of 19.17% implies A$0.19 returned on every A$1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

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 Enice Holding, which is 9.64%. Given a positive discrepancy of 9.53% between return and cost, this indicates that Enice Holding pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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

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 Enice Holding’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Enice Holding’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 89.98%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge 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. Enice Holding’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.