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 35.2%, CIMIC Group Limited (ASX:CIM) outpaced its own industry which delivered a less exciting 16.9% over the past year. While the impressive ratio tells us that CIM has made significant profits from little equity capital, ROE doesn’t tell us if CIM has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of CIM’s ROE.

View our latest analysis for CIMIC Group

Breaking down Return on Equity

Return on Equity (ROE) weighs CIMIC Group’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.35 in earnings from this. 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. CIMIC Group’s cost of equity is 8.6%. Since CIMIC Group’s return covers its cost in excess of 26.7%, its use of equity capital is efficient and likely to be sustainable. Simply put, CIMIC Group pays less for its capital than what it generates in return. ROE can be split up into three useful 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 CIMIC Group’s 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 CIMIC Group’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 42.6%, which means its above-average ROE is driven by its ability to grow its profit without a significant 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. CIMIC Group’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.