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Alibaba Group Holding Limited (NYSE:BABA) delivered an ROE of 15.14% over the past 12 months, which is an impressive feat relative to its industry average of 10.24% during the same period. Superficially, this looks great since we know that BABA has generated big profits with little equity capital; however, ROE doesn’t tell us how much BABA has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether BABA’s ROE is actually sustainable. See our latest analysis for Alibaba Group Holding
Breaking down Return on Equity
Return on Equity (ROE) weighs Alibaba Group Holding’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Alibaba Group Holding’s equity capital deployed. Its cost of equity is 11.78%. This means Alibaba Group Holding returns enough to cover its own cost of equity, with a buffer of 3.35%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Alibaba Group Holding can generate with its current 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 Alibaba Group Holding’s debt-to-equity level. At 30.29%, Alibaba Group Holding’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large 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. Alibaba Group 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.