RXP Services Limited (ASX:RXP) delivered a less impressive 11.67% ROE over the past year, compared to the 14.20% return generated by its industry. Though RXP's recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on RXP's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RXP's returns. View our latest analysis for RXP Services

Breaking down Return on Equity

Return on Equity (ROE) weighs RXP’s profit against the level of its shareholders’ equity. It essentially shows how much RXP can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

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 RXP, which is 8.55%. While RXP’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for RXP which is encouraging. 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 RXP is with its cost management. The other component, asset turnover, illustrates how much revenue RXP can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check RXP’s historic debt-to-equity ratio. At 14.96%, RXP’s debt-to-equity ratio appears low and indicates that RXP still has room to increase leverage and grow its profits.

What this means for you:

Are you a shareholder? Even though RXP returned below the industry average, its ROE comes in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of RXP to your portfolio if your personal research is confirming what the ROE is telling you. 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%.