Macquarie Group Limited (ASX:MQG) delivered an ROE of 13.58% over the past 12 months, which is an impressive feat relative to its industry average of 8.68% during the same period. Superficially, this looks great since we know that MQG has generated big profits with little equity capital; however, ROE doesn’t tell us how much MQG has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable MQG’s ROE is. See our latest analysis for MQG
What you must know about ROE
Return on Equity (ROE) is a measure of MQG’s profit relative to its shareholders’ equity. It essentially shows how much MQG can generate in earnings given the amount of equity it has raised. 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
Returns are usually compared to costs to measure the efficiency of capital. MQG’s cost of equity is 8.55%. Since MQG’s return covers its cost in excess of 5.03%, its use of equity capital is efficient and likely to be sustainable. Simply put, MQG 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from MQG’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable MQG’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt MQG currently has. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
What this means for you:
Are you a shareholder? MQG’s ROE is impressive relative to the industry average and also covers its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more MQG shares. If you're looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.