CenturyLink Inc’s (NYSE:CTL) most recent return on equity was a substandard 2.76% relative to its industry performance of 6.74% over the past year. Though CTL's recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on CTL's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CTL's returns. Check out our latest analysis for CenturyLink

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

Return on Equity (ROE) weighs CTL’s profit against the level of its shareholders’ equity. An ROE of 2.76% implies $0.03 returned on every $1 invested. 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

ROE is measured against cost of equity in order to determine the efficiency of CTL’s equity capital deployed. Its cost of equity is 8.49%. This means CTL’s returns actually do not cover its own cost of equity, with a discrepancy of -5.73%. This isn’t sustainable as it implies, very simply, that the company pays more 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. Asset turnover shows how much revenue CTL can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable CTL’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check CTL’s historic debt-to-equity ratio. At 191.63%, CTL’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.

What this means for you:

Are you a shareholder? CTL exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Additionally, its high debt level appears to be a key driver of its ROE and is something you should be mindful of before adding more of CTL to your portfolio.

Are you a potential investor? If you are considering investing in CTL, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on CenturyLink to help you make a more informed investment decision. If you are not interested in CTL anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.

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.