With an ROE of 9.85%, MyState Limited (ASX:MYS) outpaced its own industry which delivered a less exciting 7.45% over the past year. While the impressive ratio tells us that MYS has made significant profits from little equity capital, ROE doesn’t tell us if MYS has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether MYS’s ROE is actually sustainable. Check out our latest analysis for MyState
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs MYS’s profit against the level of its shareholders’ equity. For example, if MYS invests $1 in the form of equity, it will generate $0.1 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing 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 MYS, which is 8.72%. This means MYS returns enough to cover its own cost of equity, with a buffer of 1.13%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 MYS is with its cost management. Asset turnover shows how much revenue MYS can generate with its current 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 MYS’s debt-to-equity level. At over 2.5 times, MYS’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
What this means for you:
Are you a shareholder? MYS exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more MYS shares. 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%.