With an ROE of 34.61%, Alexander & Baldwin Inc (NYSE:ALEX) outpaced its own industry which delivered a less exciting 7.30% over the past year. Superficially, this looks great since we know that ALEX has generated big profits with little equity capital; however, ROE doesn’t tell us how much ALEX has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ALEX’s ROE is actually sustainable. View our latest analysis for Alexander & Baldwin

Breaking down Return on Equity

Return on Equity (ROE) weighs Alexander & Baldwin’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.35 in earnings from this. 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. Alexander & Baldwin’s cost of equity is 8.49%. Since Alexander & Baldwin’s return covers its cost in excess of 26.11%, its use of equity capital is efficient and likely to be sustainable. Simply put, Alexander & Baldwin 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 Alexander & Baldwin 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 Alexander & Baldwin’s historic debt-to-equity ratio. At 95.95%, Alexander & Baldwin’s debt-to-equity ratio appears balanced 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. Alexander & Baldwin’s above-industry ROE is encouraging, and is also in excess of 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. Although ROE can be a useful metric, it is only a small part of diligent research.