Shire plc (LSE:SHP) delivered a less impressive 11.76% ROE over the past year, compared to the 16.09% 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 SHP’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SHP’s returns. Check out our latest analysis for Shire

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

Return on Equity (ROE) is a measure of Shire’s profit relative to 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

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 Shire, which is 9.23%. While Shire’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 Shire 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Shire can make from its 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 Shire’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 54.02%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. While Shire exhibits a weak ROE against its peers, its returns are sufficient enough to cover its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Shire’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.