Bega Cheese Limited (ASX:BGA) delivered an ROE of 22.64% over the past 12 months, which is an impressive feat relative to its industry average of 10.38% during the same period. On the surface, this looks fantastic since we know that BGA has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether BGA’s ROE is actually sustainable. Check out our latest analysis for Bega Cheese
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Bega Cheese’s profit relative to its shareholders’ equity. An ROE of 22.64% implies A$0.23 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
Returns are usually compared to costs to measure the efficiency of capital. Bega Cheese’s cost of equity is 8.55%. This means Bega Cheese returns enough to cover its own cost of equity, with a buffer of 14.09%. 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
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 shows how much revenue Bega Cheese can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Bega Cheese’s historic debt-to-equity ratio. At 46.05%, Bega Cheese’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:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Bega Cheese’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.