This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.

Lovisa Holdings Limited (ASX:LOV) outperformed the Apparel Retail industry on the basis of its ROE – producing a higher 79.5% relative to the peer average of 14.0% over the past 12 months. While the impressive ratio tells us that LOV has made significant profits from little equity capital, ROE doesn’t tell us if LOV has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether LOV’s ROE is actually sustainable.

View our latest analysis for Lovisa Holdings

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Lovisa Holdings’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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

Returns are usually compared to costs to measure the efficiency of capital. Lovisa Holdings’s cost of equity is 8.6%. Since Lovisa Holdings’s return covers its cost in excess of 70.9%, its use of equity capital is efficient and likely to be sustainable. Simply put, Lovisa Holdings pays less for its capital than what it generates in return. 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Lovisa Holdings’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Lovisa Holdings’s historic debt-to-equity ratio. Currently, Lovisa Holdings has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.