With an ROE of 9.08%, Collection House Limited (ASX:CLH) outpaced its own industry which delivered a less exciting 9.08% over the past year. On the surface, this looks fantastic since we know that CLH has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of CLH’s ROE. See our latest analysis for Collection House
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Collection House’s profit relative to its shareholders’ equity. An ROE of 9.08% implies A$0.09 returned on every A$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
Returns are usually compared to costs to measure the efficiency of capital. Collection House’s cost of equity is 8.55%. This means Collection House returns enough to cover its own cost of equity, with a buffer of 0.53%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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. Asset turnover reveals how much revenue can be generated from Collection House’s 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 Collection House’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 70.63%, meaning the ROE is a result of 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. Collection House’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. Although ROE can be a useful metric, it is only a small part of diligent research.