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Illinois Tool Works Inc (NYSE:ITW) delivered an ROE of 43.31% over the past 12 months, which is an impressive feat relative to its industry average of 11.58% during the same period. Superficially, this looks great since we know that ITW has generated big profits with little equity capital; however, ROE doesn’t tell us how much ITW has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ITW’s ROE is actually sustainable. See our latest analysis for Illinois Tool Works
What you must know about ROE
Return on Equity (ROE) is a measure of Illinois Tool Works’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.43 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
Returns are usually compared to costs to measure the efficiency of capital. Illinois Tool Works’s cost of equity is 9.74%. This means Illinois Tool Works returns enough to cover its own cost of equity, with a buffer of 33.57%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 shows how much revenue Illinois Tool Works can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Illinois Tool Works’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a high 181.34%, meaning the above-average ratio is a result of a large amount of debt.
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. Illinois Tool Works’s above-industry ROE is encouraging, and is also in excess of its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.