Medibank Private Limited (ASX:MPL) delivered an ROE of 26.04% over the past 12 months, which is an impressive feat relative to its industry average of 14.99% during the same period. While the impressive ratio tells us that MPL has made significant profits from little equity capital, ROE doesn’t tell us if MPL has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether MPL’s ROE is actually sustainable. See our latest analysis for Medibank Private
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Medibank Private’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Medibank Private’s cost of equity is 8.55%. Given a positive discrepancy of 17.49% between return and cost, this indicates that Medibank Private 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Medibank Private 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 ROE can be inflated by excessive debt, we need to examine Medibank Private’s debt-to-equity level. Currently, Medibank Private 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.
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. Medibank Private’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.