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With an ROE of 16.46%, Sonova Holding AG (SWX:SOON) outpaced its own industry which delivered a less exciting 14.09% over the past year. Superficially, this looks great since we know that SOON has generated big profits with little equity capital; however, ROE doesn’t tell us how much SOON has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable SOON’s ROE is. Check out our latest analysis for Sonova Holding
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests CHF1 in the form of equity, it will generate CHF0.16 in earnings from this. 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 Sonova Holding’s equity capital deployed. Its cost of equity is 9.13%. Given a positive discrepancy of 7.33% between return and cost, this indicates that Sonova 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
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 shows how much revenue Sonova Holding 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 Sonova Holding currently has. Currently the debt-to-equity ratio stands at a low 30.68%, 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. Sonova Holding’s ROE is impressive relative to the industry average and also covers 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.