Veritas Investments Limited (NZSE:VIL) delivered an ROE of 53.33% over the past 12 months, which is an impressive feat relative to its industry average of 21.04% during the same period. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for VIL
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of VIL’s profit relative to its shareholders’ equity.An ROE of 53.33% implies $0.53 returned on every $1 invested, so the higher the return, the better.Investors that are diversifying their portfolio based on industry may want to maximise their return in the Packaged Foods and Meats sector by choosing the highest returning stock.However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for VIL, which is 8.55%. Given a positive discrepancy of 44.78% between return and cost, this indicates that VIL pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the 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.The other component, asset turnover, illustrates how much revenue VIL can make from its asset base.The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage.We can assess whether VIL is fuelling ROE by excessively raising debt. Ideally, VIL should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands is significantly high, above 2.5 times, meaning VIL has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.
ROE – It’s not just another ratio
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. VIL’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of VIL’s returns. There are other important measures we need to consider in order to conclude on the quality of its returns. I recommend you see our latest FREE analysis report to find out more about other measures!
If you are not interested in VIL anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.
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