Broadcom Limited (NASDAQ:AVGO) delivered a less impressive 7.72% ROE over the past year, compared to the 11.80% return generated by its industry. Though AVGO’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on AVGO’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of AVGO’s returns. See our latest analysis for Broadcom

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Broadcom’s profit against the level of its shareholders’ equity. An ROE of 7.72% implies $0.08 returned on every $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 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 Broadcom, which is 10.61%. Given a discrepancy of -2.89% between return and cost, this indicated that Broadcom may be paying more for its capital than what it’s generating 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Broadcom can make from its 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 Broadcom currently has. At 75.68%, Broadcom’s debt-to-equity ratio appears sensible and indicates its 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. Broadcom’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.