With an ROE of 16.41%, AGC Networks Limited (NSEI:AGCNET) outpaced its own industry which delivered a less exciting 15.15% over the past year. On the surface, this looks fantastic since we know that AGCNET has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether AGCNET’s ROE is actually sustainable. View our latest analysis for AGC Networks
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs AGC Networks’s profit against the level of 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 measured against cost of equity in order to determine the efficiency of AGC Networks’s equity capital deployed. Its cost of equity is 13.40%. This means AGC Networks returns enough to cover its own cost of equity, with a buffer of 3.01%. This sustainable practice implies that the company pays less 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from AGC Networks’s 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 AGC Networks’s debt-to-equity level. Currently the debt-to-equity ratio stands at a high 232.88%, which means its above-average ROE is driven by significant debt levels.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. AGC Networks exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of AGC Networks’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.