Data#3 Limited (ASX:DTL) delivered an ROE of 35.12% over the past 12 months, which is an impressive feat relative to its industry average of 15.29% during the same period. While the impressive ratio tells us that DTL has made significant profits from little equity capital, ROE doesn’t tell us if DTL has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether DTL’s ROE is actually sustainable. See our latest analysis for Data#3
What you must know about ROE
Return on Equity (ROE) is a measure of Data#3’s profit relative to its shareholders’ equity. It essentially shows how much the company 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 measured against cost of equity in order to determine the efficiency of Data#3’s equity capital deployed. Its cost of equity is 8.55%. Since Data#3’s return covers its cost in excess of 26.57%, its use of equity capital is efficient and likely to be sustainable. Simply put, Data#3 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 Data#3 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 artificially increased through excessive borrowing, we should check Data#3’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 1.53%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
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. Data#3’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.