Comvita Limited (NZSE:CVT) delivered a less impressive 11.06% ROE over the past year, compared to the 15.82% 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 CVT’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of CVT’s returns. Let me show you what I mean by this. See our latest analysis for Comvita

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Comvita’s profit against the level of its shareholders’ equity. For example, if the company invests NZ$1 in the form of equity, it will generate NZ$0.11 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

Returns are usually compared to costs to measure the efficiency of capital. Comvita’s cost of equity is 8.55%. While Comvita’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 Comvita 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. Asset turnover reveals how much revenue can be generated from Comvita’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Comvita currently has. At 46.72%, Comvita’s debt-to-equity ratio appears low and indicates that Comvita still has room to increase leverage and grow its profits.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Even though Comvita returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Comvita’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.