KTM Industries AG (WBAG:CIAG) outperformed the Motorcycle Manufacturers industry on the basis of its ROE – producing a higher 15.87% relative to the peer average of 15.80% over the past 12 months. Superficially, this looks great since we know that CIAG has generated big profits with little equity capital; however, ROE doesn’t tell us how much CIAG has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether CIAG’s ROE is actually sustainable. Check out our latest analysis for KTM Industries
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.16 in earnings from this. 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 KTM Industries, which is 10.52%. This means KTM Industries returns enough to cover its own cost of equity, with a buffer of 5.35%. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue KTM Industries 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 KTM Industries’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 102.92%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.