Pilgrim's Pride Corporation (NASDAQ:PPC) delivered an ROE of 49.02% over the past 12 months, which is an impressive feat relative to its industry average of 20.82% during the same period. But what is more interesting is whether PPC can sustain this above-average ratio. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. View our latest analysis for Pilgrim's Pride

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.For example, if PPC invests $1 in the form of equity, it will generate $0.49 in earnings from this.Investors that are diversifying their portfolio based on industry may want to maximise their return in the Packaged Foods and Meats sector by choosing the highest returning stock.However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt PPC has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of PPC’s equity capital deployed. Its cost of equity is 8.49%. This means PPC returns enough to cover its own cost of equity, with a buffer of 40.52%. 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 PPC is with its cost management.Asset turnover reveals how much revenue can be generated from PPC’s asset base.The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage.We can assess whether PPC is fuelling ROE by excessively raising debt. Ideally, PPC should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 119.36%, which is relatively balanced. This means PPC has not taken on excessive leverage, and its above-average ROE is driven by its ability to grow its profit without a significant debt burden.