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Ramsay Health Care Limited (ASX:RHC) outperformed the Healthcare Facilities industry on the basis of its ROE – producing a higher 21.11% relative to the peer average of 11.41% over the past 12 months. Superficially, this looks great since we know that RHC has generated big profits with little equity capital; however, ROE doesn’t tell us how much RHC has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable RHC’s ROE is. View our latest analysis for Ramsay Health Care
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 21.11% implies A$0.21 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Ramsay Health Care, which is 8.55%. This means Ramsay Health Care returns enough to cover its own cost of equity, with a buffer of 12.56%. This sustainable practice implies that the company 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Ramsay Health Care can generate with its current 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 Ramsay Health Care’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 151.87%, meaning the above-average ratio is a result of a large amount of debt.
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. Ramsay Health Care’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.