XPO Logistics Inc (NYSE:XPO) delivered a less impressive 8.98% ROE over the past year, compared to the 12.53% return generated by its industry. Though XPO’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 XPO’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of XPO’s returns. Check out our latest analysis for XPO Logistics

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

Return on Equity (ROE) is a measure of XPO Logistics’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.09 in earnings from this. 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. XPO Logistics’s cost of equity is 12.14%. Since XPO Logistics’s return does not cover its cost, with a difference of -3.16%, this means its current use of equity is not efficient and not sustainable. Very simply, XPO Logistics 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

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 XPO Logistics’s 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 the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check XPO Logistics’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a balanced 116.40%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.

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. XPO Logistics’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of XPO Logistics’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.