Computershare Limited (ASX:CPU) outperformed the Data Processing and Outsourced Services industry on the basis of its ROE – producing a higher 23.19% relative to the peer average of 14.20% over the past 12 months. On the surface, this looks fantastic since we know that CPU 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 CPU’s ROE is actually sustainable. Check out our latest analysis for Computershare

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs CPU’s profit against the level of its shareholders’ equity. For example, if CPU invests A$1 in the form of equity, it will generate A$0.23 in earnings from this. 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

Returns are usually compared to costs to measure the efficiency of capital. CPU’s cost of equity is 8.55%. This means CPU returns enough to cover its own cost of equity, with a buffer of 14.63%. 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

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 CPU can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable CPU’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CPU’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 127.16%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

What this means for you:

Are you a shareholder? CPU’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of CPU 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%.