With an ROE of 25.21%, Koninklijke DSM NV. (ENXTAM:DSM) outpaced its own industry which delivered a less exciting 13.22% over the past year. Superficially, this looks great since we know that DSM has generated big profits with little equity capital; however, ROE doesn’t tell us how much DSM has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether DSM’s ROE is actually sustainable. See our latest analysis for Koninklijke DSM
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 25.21% implies €0.25 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 Koninklijke DSM, which is 9.13%. Since Koninklijke DSM’s return covers its cost in excess of 16.08%, its use of equity capital is efficient and likely to be sustainable. Simply put, Koninklijke DSM pays less for its capital than what it generates in return. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue Koninklijke DSM can make from its 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 artificially increased through excessive borrowing, we should check Koninklijke DSM’s historic debt-to-equity ratio. At 37.47%, Koninklijke DSM’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large 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. Koninklijke DSM’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.