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Ennis Inc (NYSE:EBF) outperformed the Commercial Printing industry on the basis of its ROE – producing a higher 12.52% relative to the peer average of 12.04% over the past 12 months. While the impressive ratio tells us that EBF has made significant profits from little equity capital, ROE doesn’t tell us if EBF has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether EBF’s ROE is actually sustainable. View our latest analysis for Ennis
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of 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 Ennis, which is 8.49%. This means Ennis returns enough to cover its own cost of equity, with a buffer of 4.02%. This sustainable practice implies that the company 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 Ennis’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 artificially increased through excessive borrowing, we should check Ennis’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 11.46%, which means its above-average ROE is driven by its ability to grow its profit without a significant 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. Ennis’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. Although ROE can be a useful metric, it is only a small part of diligent research.