West Coast Paper Mills Limited (NSEI:WSTCSTPAPR) delivered an ROE of 29.83% over the past 12 months, which is an impressive feat relative to its industry average of 13.88% during the same period. On the surface, this looks fantastic since we know that WSTCSTPAPR has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether WSTCSTPAPR’s ROE is actually sustainable. View our latest analysis for West Coast Paper Mills
What you must know about ROE
Return on Equity (ROE) weighs West Coast Paper Mills’s profit against the level of its shareholders’ equity. It essentially shows how much the company 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 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 West Coast Paper Mills, which is 13.82%. Since West Coast Paper Mills’s return covers its cost in excess of 16.01%, its use of equity capital is efficient and likely to be sustainable. Simply put, West Coast Paper Mills 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from West Coast Paper Mills’s 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 West Coast Paper Mills’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 63.79%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. West Coast Paper Mills’s above-industry ROE is encouraging, and is also in excess of 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. Although ROE can be a useful metric, it is only a small part of diligent research.