Livestock Improvement Corporation Limited (NZSE:LIC) delivered a less impressive 6.66% ROE over the past year, compared to the 14.32% return generated by its industry. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into LIC’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of LIC’s returns. Let me show you what I mean by this. View our latest analysis for Livestock Improvement

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

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.07 in earnings from this. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Livestock Improvement, which is 8.55%. Since Livestock Improvement’s return does not cover its cost, with a difference of -1.89%, this means its current use of equity is not efficient and not sustainable. Very simply, Livestock Improvement pays more for its capital than what it generates in return. ROE can be broken down into three different 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. The other component, asset turnover, illustrates how much revenue Livestock Improvement can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Livestock Improvement currently has. Currently the debt-to-equity ratio stands at a low 18.27%, which means Livestock Improvement still has headroom to take on more leverage in order to increase profits.