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With an ROE of 10.51%, Allianz SE (DB:ALV) outpaced its own industry which delivered a less exciting 9.38% over the past year. Superficially, this looks great since we know that ALV has generated big profits with little equity capital; however, ROE doesn’t tell us how much ALV has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ALV’s ROE is actually sustainable. Check out our latest analysis for Allianz
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company 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 Allianz’s equity capital deployed. Its cost of equity is 8.60%. Since Allianz’s return covers its cost in excess of 1.91%, its use of equity capital is efficient and likely to be sustainable. Simply put, Allianz 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Allianz can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Allianz’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 51.95%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Allianz’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.