Altium Limited (ASX:ALU) delivered an ROE of 23.34% over the past 12 months, which is an impressive feat relative to its industry average of 20.59% during the same period. Superficially, this looks great since we know that ALU has generated big profits with little equity capital; however, ROE doesn’t tell us how much ALU has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ALU’s ROE is actually sustainable. View our latest analysis for Altium
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Altium’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.23 in earnings from this. 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 Altium, which is 9.99%. This means Altium returns enough to cover its own cost of equity, with a buffer of 13.35%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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. The other component, asset turnover, illustrates how much revenue Altium can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Altium currently has. Currently, Altium has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.