Ridley Corporation Limited (ASX:RIC) delivered a less impressive 9.26% ROE over the past year, compared to the 10.38% return generated by its industry. RIC’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on RIC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of RIC’s returns. View our latest analysis for Ridley
What you must know about ROE
Return on Equity (ROE) weighs Ridley’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
Returns are usually compared to costs to measure the efficiency of capital. Ridley’s cost of equity is 8.55%. Some of Ridley’s peers may have a higher ROE but its cost of equity could exceed this return, leading to an unsustainable negative discrepancy i.e. the company spends more than it earns. This is not the case for Ridley which is reassuring. 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 Ridley’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Ridley’s debt-to-equity level. At 31.00%, Ridley’s debt-to-equity ratio appears low and indicates that Ridley still has room to increase leverage and grow its profits.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Although Ridley’s ROE is underwhelming relative to the industry average, its returns are high enough to cover the cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Ridley’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.