In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
With an ROE of 19.1%, Appen Limited (ASX:APX) outpaced its own industry which delivered a less exciting 14.3% over the past year. Superficially, this looks great since we know that APX has generated big profits with little equity capital; however, ROE doesn’t tell us how much APX has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of APX’s ROE.
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Breaking down Return on Equity
Return on Equity (ROE) weighs Appen’s profit against the level of its shareholders’ equity. An ROE of 19.1% implies A$0.19 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. Appen’s cost of equity is 8.6%. This means Appen returns enough to cover its own cost of equity, with a buffer of 10.5%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Appen’s 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 artificially increased through excessive borrowing, we should check Appen’s historic debt-to-equity ratio. At 61.3%, Appen’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Appen’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.