Applied Materials Inc (NASDAQ:AMAT) outperformed the Semiconductor Equipment industry on the basis of its ROE – producing a higher 41.46% relative to the peer average of 11.56% over the past 12 months. On the surface, this looks fantastic since we know that AMAT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable AMAT’s ROE is. See our latest analysis for Applied Materials
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Applied Materials’s profit against the level of its shareholders’ equity. An ROE of 41.46% implies $0.41 returned on every $1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 Applied Materials, which is 10.21%. This means Applied Materials returns enough to cover its own cost of equity, with a buffer of 31.24%. 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 Applied Materials’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 Applied Materials’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 56.73%, which means its above-average 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. Applied Materials’s above-industry ROE is encouraging, and is also in excess of 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.