I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.

Datalogic SpA (BIT:DAL) delivered an ROE of 17.16% over the past 12 months, which is an impressive feat relative to its industry average of 13.25% during the same period. While the impressive ratio tells us that DAL has made significant profits from little equity capital, ROE doesn’t tell us if DAL has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether DAL’s ROE is actually sustainable.

View our latest analysis for Datalogic

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Datalogic’s profit relative to its shareholders’ equity. An ROE of 17.16% implies €0.17 returned on every €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 Datalogic, which is 9.50%. Given a positive discrepancy of 7.66% between return and cost, this indicates that Datalogic pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 shows how much revenue Datalogic 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 the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Datalogic’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 66.75%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Datalogic’s ROE is impressive relative to the industry average and also covers 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.