Questus Limited (ASX:QSS) outperformed the Asset Management and Custody Banks industry on the basis of its ROE – producing a higher 8.86% relative to the peer average of 8.70% over the past 12 months. On the surface, this looks fantastic since we know that QSS 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 QSS’s ROE is actually sustainable. See our latest analysis for QSS

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs QSS’s profit against the level of its shareholders’ equity. For example, if QSS invests A$1 in the form of equity, it will generate A$0.09 in earnings from this. 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 QSS, which is 8.55%. Given a positive discrepancy of 0.31% between return and cost, this indicates that QSS pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 QSS is with its cost management. Asset turnover shows how much revenue QSS can generate with its current 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 QSS currently has. The debt-to-equity ratio currently stands at over 2.5 times, meaning the above-average ratio is a result of a large amount of debt.

What this means for you:

Are you a shareholder? QSS exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more QSS shares. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.