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With an ROE of 12.92%, Chipotle Mexican Grill Inc (NYSE:CMG) outpaced its own industry which delivered a less exciting 11.01% over the past year. On the surface, this looks fantastic since we know that CMG 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 CMG’s ROE is. See our latest analysis for Chipotle Mexican Grill
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Chipotle Mexican Grill’s profit against the level of its shareholders’ equity. An ROE of 12.92% implies $0.13 returned on every $1 invested. 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
ROE is measured against cost of equity in order to determine the efficiency of Chipotle Mexican Grill’s equity capital deployed. Its cost of equity is 9.52%. Given a positive discrepancy of 3.40% between return and cost, this indicates that Chipotle Mexican Grill 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 Chipotle Mexican Grill 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 Chipotle Mexican Grill’s debt-to-equity level. Currently, Chipotle Mexican Grill 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. Chipotle Mexican Grill’s ROE is impressive relative to the industry average and also covers 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.