With an ROE of 25.26%, AmerisourceBergen Corporation (NYSE:ABC) outpaced its own industry which delivered a less exciting 13.80% over the past year. On the surface, this looks fantastic since we know that ABC has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ABC’s ROE is. See our latest analysis for AmerisourceBergen
What you must know about ROE
Return on Equity (ROE) is a measure of AmerisourceBergen’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. AmerisourceBergen’s cost of equity is 8.59%. Given a positive discrepancy of 16.67% between return and cost, this indicates that AmerisourceBergen pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 AmerisourceBergen 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 inflated by excessive debt, we need to examine AmerisourceBergen’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 145.47%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge 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. AmerisourceBergen’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.