Inventis Limited (ASX:IVT) outperformed the Office Services and Supplies industry on the basis of its ROE – producing a higher 14.77% relative to the peer average of 9.05% over the past 12 months. On the surface, this looks fantastic since we know that IVT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable IVT’s ROE is. View our latest analysis for Inventis
What you must know about ROE
Return on Equity (ROE) weighs IVT’s profit against the level of its shareholders’ equity. It essentially shows how much IVT can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of IVT’s equity capital deployed. Its cost of equity is 8.55%. This means IVT returns enough to cover its own cost of equity, with a buffer of 6.22%. 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 IVT is with its cost management. The other component, asset turnover, illustrates how much revenue IVT can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine IVT’s debt-to-equity level. The debt-to-equity ratio currently stands at over 2.5 times, meaning the above-average ratio is a result of a large amount of debt.
What this means for you:
Are you a shareholder? IVT’s above-industry ROE is encouraging, and is also in excess of its cost of equity. However, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of IVT to your portfolio. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.