With an ROE of 33.68%, Fair Isaac Corporation (NYSE:FICO) outpaced its own industry which delivered a less exciting 13.35% over the past year. On the surface, this looks fantastic since we know that FICO has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable FICO’s ROE is. View our latest analysis for Fair Isaac

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Fair Isaac’s profit against the level of its shareholders’ equity. It essentially shows how much the company 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. Fair Isaac’s cost of equity is 10.25%. Since Fair Isaac’s return covers its cost in excess of 23.43%, its use of equity capital is efficient and likely to be sustainable. Simply put, Fair Isaac 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Fair Isaac’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Fair Isaac’s debt-to-equity level. Currently the debt-to-equity ratio stands at a high 189.87%, which means its above-average ROE is driven by significant debt levels.

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. Fair Isaac exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Fair Isaac’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.