With an ROE of 12.25%, Wesfarmers Limited (ASX:WES) outpaced its own industry which delivered a less exciting 11.84% over the past year. While the impressive ratio tells us that WES has made significant profits from little equity capital, ROE doesn’t tell us if WES has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WES’s ROE. Check out our latest analysis for Wesfarmers
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of WES’s profit relative to its shareholders’ equity. For example, if WES invests A$1 in the form of equity, it will generate A$0.12 in earnings from this. 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. WES’s cost of equity is 8.55%. This means WES returns enough to cover its own cost of equity, with a buffer of 3.70%. This sustainable practice implies that the company pays less for its capital than what it generates 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from WES’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine WES’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 22.61%, 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? WES’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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%.