Wisetech Global Limited’s (ASX:WTC) most recent return on equity was a substandard 15.71% relative to its industry performance of 20.74% over the past year. Though WTC’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 WTC’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of WTC’s returns. Let me show you what I mean by this. See our latest analysis for Wisetech Global
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Wisetech Global’s profit relative to its shareholders’ equity. An ROE of 15.71% implies A$0.16 returned on every A$1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Wisetech Global’s cost of equity is 9.18%. While Wisetech Global’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Wisetech Global which is encouraging. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Wisetech Global 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 the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Wisetech Global’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 1.80%, which means Wisetech Global still has headroom to take on more leverage in order to increase profits.
What this means for you:
Are you a shareholder? While WTC exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity, which means its generating value for shareholders. Since ROE is not inflated by excessive debt, it might be a good time to add more of WTC to your portfolio if your personal research is confirming what the ROE is telling you. 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%.