D4t4 Solutions Plc (AIM:D4T4) outperformed the IT Consulting and Other Services industry on the basis of its ROE – producing a higher 24.25% relative to the peer average of 14.96% over the past 12 months. Superficially, this looks great since we know that D4T4 has generated big profits with little equity capital; however, ROE doesn’t tell us how much D4T4 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable D4T4’s ROE is. See our latest analysis for D4T4

Breaking down Return on Equity

Return on Equity (ROE) weighs D4T4’s profit against the level of its shareholders’ equity. It essentially shows how much D4T4 can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of D4T4’s equity capital deployed. Its cost of equity is 8.30%. Given a positive discrepancy of 15.95% between return and cost, this indicates that D4T4 pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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 shows how much revenue D4T4 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 D4T4’s historic debt-to-equity ratio. At 7.52%, D4T4’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.

What this means for you:

Are you a shareholder? D4T4’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.