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IMCD NV. (ENXTAM:IMCD) outperformed the Trading Companies and Distributors industry on the basis of its ROE – producing a higher 10.60% relative to the peer average of 10.15% over the past 12 months. Superficially, this looks great since we know that IMCD has generated big profits with little equity capital; however, ROE doesn’t tell us how much IMCD has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of IMCD’s ROE. Check out our latest analysis for IMCD
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs IMCD’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.11 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. IMCD’s cost of equity is 8.14%. This means IMCD returns enough to cover its own cost of equity, with a buffer of 2.45%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from IMCD’s 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 IMCD’s debt-to-equity level. At 75.71%, IMCD’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. IMCD’s ROE is impressive relative to the industry average and also covers 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.