With an ROE of 22.63%, Johnson & Johnson (NYSE:JNJ) outpaced its own industry which delivered a less exciting 18.27% over the past year. Superficially, this looks great since we know that JNJ has generated big profits with little equity capital; however, ROE doesn’t tell us how much JNJ has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether JNJ’s ROE is actually sustainable. See our latest analysis for JNJ

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of JNJ’s profit relative to its shareholders’ equity. An ROE of 22.63% implies $0.23 returned on every $1 invested. 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. JNJ’s cost of equity is 8.49%. Since JNJ’s return covers its cost in excess of 14.13%, its use of equity capital is efficient and likely to be sustainable. Simply put, JNJ 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 JNJ is with its cost management. The other component, asset turnover, illustrates how much revenue JNJ 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 JNJ’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt JNJ currently has. Currently the debt-to-equity ratio stands at a low 48.45%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

What this means for you:

Are you a shareholder? JNJ’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.

Are you a potential investor? If you are considering investing in JNJ, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Johnson & Johnson to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.