This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
With an ROE of 13.8%, Asahi Songwon Colors Limited (NSE:ASAHISONG) outpaced its own industry which delivered a less exciting 13.1% over the past year. On the surface, this looks fantastic since we know that ASAHISONG has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether ASAHISONG’s ROE is actually sustainable.
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What you must know about ROE
Return on Equity (ROE) is a measure of Asahi Songwon Colors’s profit relative to 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. Asahi Songwon Colors’s cost of equity is 13.5%. Since Asahi Songwon Colors’s return covers its cost in excess of 0.3%, its use of equity capital is efficient and likely to be sustainable. Simply put, Asahi Songwon Colors 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
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 Asahi Songwon Colors 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 Asahi Songwon Colors’s debt-to-equity level. At 38.7%, Asahi Songwon Colors’s debt-to-equity ratio appears low 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. Asahi Songwon Colors’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.