InterDigital Inc (NASDAQ:IDCC) delivered an ROE of 48.71% over the past 12 months, which is an impressive feat relative to its industry average of 16.61% during the same period. Though, the impressiveness of IDCC’s ROE is contingent on whether this industry-beating level can be sustained. A measure of sustainable returns is IDCC’s financial leverage. If IDCC borrows debt to invest in its business, its profits will be higher. But ROE does not capture any debt, so we only see high profits and low equity, which is great on the surface. But today let’s take a deeper dive below this surface. View our latest analysis for InterDigital

What you must know about ROE

Return on Equity (ROE) weighs IDCC’s profit against the level of its shareholders’ equity.It essentially shows how much IDCC can generate in earnings given the amount of equity it has raised.If investors diversify their portfolio by industry, they may want to maximise their return in the Communications Equipment sector by investing in the highest returning stock.However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt IDCC has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of IDCC’s equity capital deployed. Its cost of equity is 10.16%. This means IDCC returns enough to cover its own cost of equity, with a buffer of 38.55%. 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 IDCC is with its cost management.Asset turnover shows how much revenue IDCC can generate with its current asset base.The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage.We can determine if IDCC’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at IDCC’s debt-to-equity ratio. Currently the ratio stands at 34.56%, which is very low. This means IDCC has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.