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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about Return on Equity using a real-life example.
Wagners Holding Company Limited (ASX:WGN) delivered an ROE of 41.8% over the past 12 months, which is an impressive feat relative to its industry average of 16.0% during the same period. On the surface, this looks fantastic since we know that WGN 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 WGN’s ROE is actually sustainable.
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Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Wagners Holding’s profit against the level of its shareholders’ equity. An ROE of 41.8% implies A$0.42 returned on every A$1 invested. 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 Wagners Holding’s equity capital deployed. Its cost of equity is 8.6%. Given a positive discrepancy of 33.3% between return and cost, this indicates that Wagners Holding pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct 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 Wagners Holding’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Wagners Holding’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a balanced 142%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Wagners Holding exhibits a strong ROE against its peers, as well as sufficient returns to cover 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.