With an ROE of 31.27%, Alliance Data Systems Corporation (NYSE:ADS) outpaced its own industry which delivered a less exciting 13.86% over the past year. While the impressive ratio tells us that ADS has made significant profits from little equity capital, ROE doesn’t tell us if ADS has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ADS’s ROE. View our latest analysis for Alliance Data Systems

What you must know about ROE

Return on Equity (ROE) weighs Alliance Data Systems’s profit against the level of its shareholders’ equity. An ROE of 31.27% implies $0.31 returned on every $1 invested. 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

Returns are usually compared to costs to measure the efficiency of capital. Alliance Data Systems’s cost of equity is 16.43%. This means Alliance Data Systems returns enough to cover its own cost of equity, with a buffer of 14.84%. 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

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 Alliance Data Systems’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 Alliance Data Systems’s debt-to-equity level. The debt-to-equity ratio currently stands at over 2.5 times, meaning the above-average ratio is a result of a large amount of debt.

What this means for you:

Are you a shareholder? ADS’s above-industry ROE is encouraging, and is also in excess of its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more ADS shares. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.