Cleanaway Waste Management Limited’s (ASX:CWY) most recent return on equity was a substandard 4.02% relative to its industry performance of 9.12% over the past year. Though CWY's recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on CWY's below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CWY's returns. Check out our latest analysis for Cleanaway Waste Management

What you must know about ROE

Return on Equity (ROE) weighs CWY’s profit against the level of its shareholders’ equity. It essentially shows how much CWY can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of CWY’s equity capital deployed. Its cost of equity is 8.55%. Since CWY’s return does not cover its cost, with a difference of -4.53%, this means its current use of equity is not efficient and not sustainable. Very simply, CWY pays more 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient CWY is with its cost management. Asset turnover shows how much revenue CWY can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable CWY’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CWY’s debt-to-equity level. At 20.29%, CWY’s debt-to-equity ratio appears low and indicates that CWY still has room to increase leverage and grow its profits.

What this means for you:

Are you a shareholder? CWY’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as CWY still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.