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This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
BAE Systems plc (LON:BA.) delivered an ROE of 13.56% over the past 12 months, which is an impressive feat relative to its industry average of 12.83% during the same period. While the impressive ratio tells us that BA. has made significant profits from little equity capital, ROE doesn’t tell us if BA. has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether BA.’s ROE is actually sustainable.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs BAE Systems’s profit against the level of its shareholders’ equity. An ROE of 13.56% implies £0.14 returned on every £1 invested. 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 measured against cost of equity in order to determine the efficiency of BAE Systems’s equity capital deployed. Its cost of equity is 8.28%. This means BAE Systems returns enough to cover its own cost of equity, with a buffer of 5.28%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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 shows how much revenue BAE Systems can generate with its current 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 BAE Systems’s historic debt-to-equity ratio. At 70.85%, BAE Systems’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large 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. BAE Systems’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.