With an ROE of 13.57%, Waddell & Reed Financial Inc (NYSE:WDR) outpaced its own industry which delivered a less exciting 12.81% over the past year. While the impressive ratio tells us that WDR has made significant profits from little equity capital, ROE doesn’t tell us if WDR has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WDR’s ROE. View our latest analysis for Waddell & Reed Financial

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Waddell & Reed Financial’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Waddell & Reed Financial’s equity capital deployed. Its cost of equity is 9.09%. Since Waddell & Reed Financial’s return covers its cost in excess of 4.48%, its use of equity capital is efficient and likely to be sustainable. Simply put, Waddell & Reed Financial pays less for its capital than what it generates in return. ROE can be split up into three useful 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Waddell & Reed Financial can make from its 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 Waddell & Reed Financial’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 21.06%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

What this means for you:

Are you a shareholder? WDR’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of WDR to your portfolio if your personal research is confirming what the ROE is telling you. 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%.